A Functional Perspective of Financial Intermediation Robert C. Merton

A Functional Perspective of Financial Intermediation
Author(s): Robert C. Merton

Source: Financial Management , Summer, 1995, Vol. 24, No. 2, Silver Anniversary
Commemoration (Summer, 1995), pp. 23-41
Published by: Wiley on behalf of the Financial Management Association International
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A Functional Perspective of Financial
Intermediation
Robert C. Merton
Robert C. Merton is George F. Baker New financial product designs, improved computer and telecommunications
Professor of Business Administration at the technology, and advances in the theory of finance have led to dramatic and rapid
Graduate School of Business, Harvard changes in the structure of global financial markets and institutions. This paper offers
University, Boston, MA.
a functional perspective as the conceptual framework for analyzing the dynamics of
institutional changes in financial intermediation and uses a series of examples to
illustrate the range of institutional change that is likely to occur. These examples are
used to frame the managerial issues surrounding the production process for
intermediaries and to discuss the regulatory process for those intermediaries.
0 There are two fundamentally different frames of reference to the institutional perspective, this functional perspective
for analysis of financial intermediation. One perspective does not posit that existing institutions, whether
takes as given the existing institutional structure of financial operating or regulatory, will necessarily be preserved.
intermediaries and views the objective of public policy as Instead, its structure rests on two basic premises: 1) financial
helping the institutions currently in place to survive and functions are more stable than financial institutions-that is,
flourish. Framed in terms of the banks, or the insurance functions change less over time and vary less across
companies, private-sector managerial objectives aregeopolitical boundaries; and 2) competition will cause the
similarly posed in terms of what can be done to make those changes in institutional structure to evolve toward greater
institutions perform their particular intermediation services efficiency in the performance of the financial system.
more efficiently and profitably. How would one go about designing a completely new
An alternative to the institutional perspective-and the financial system for a country? This question is, of course,
one I take here-is thefunctional perspective. The functional no longer a matter of only academic interest. Policymakers
perspective takes as given the economic functions performedaround the world are working on fundamental changes to the
by financial intermediaries and asks what is the best financial systems of their countries. Changing the financial
institutional structure to perform those functions.1 In contrastsystem in the former Communist countries of Eastern Europe
is a major part of a general restructuring of their entire
I thank the Editors for helpful editorial suggestions. Support from the Global economic system from one based on central planning and
Financial System project, Harvard Business School, is gratefully government ownership of business to one based on free
acknowledged.
markets and private ownership. The functional perspective
Editors' Note: This paper is a revised and shortened version of Merton
(1993), reproduced in part here by permission of the Economic Council. on intermediation can be particularly useful in institutional
Robert C. Merton graciously agreed to adapt this article for the journal to design in such cases.
commemorate the Association's twenty-fifth anniversary. Professor Merton
In building a financial system from scratch, one
started in the profession after graduating from MIT 25 years ago, as it
happens, in the same year FMA was founded. Since then, he has given understandably begins by defining its central role. The
tremendously to the profession. In addition to his many significant primary function of any financial system is to facilitate the
contributions to the finance literature, he has served in numerous capacities,
including as a founding Co-editor of the Journal of Financial Economics allocation and deployment of economic resources, both
from 1974-1977, an Associate Editor of the JFE from 1977-1983, and the spatially and temporally, in an uncertain environment.
President of the American Finance Association (1986). He will give the
Keynote Address at the FMA's 1995 Annual Meeting in New York City.
Cossin (1993), Jensen and Meckling (1976), Leland and Pyle (1977), Pierce
1For an in-depth discussion of the functional perspective as a tool of analysis, (1991), Scholes and Wolfson (1992), and Williamson (1985 and 1988).
see Bodie and Merton (1993) and Merton and Bodie (1993 and 1995). This Financial functions are used in a different analytical framework in Diamond
mode of analysis fits with the approaches of Black (1985), Brennan (1993), and Dybvig (1986) and Greenbaum and Higgins (1983).
Financial Management, Vol. 24, No. 2, Summer 1995, pages 23-41.

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24 FINANCIAL MANAGEMENT / SUMMER 1995
From the most

aggregated
issues for an intermediary fromlevel of
those of a typical the
business
function of
resource allocation,
firm. Thus, we
risk management is almost always can
an activity of fu
six core functions performed by the financ
first-order importance to the efficient operation of an
Function 1: A intermediary but, insystem
financial general, need not be so provide
for business
system for firms. Similarly,
the exchange acquiring or issuing of
guarantees of financial
goods an
services. performance is an operating activity of first importance for
intermediaries but only a specialized transaction for most
Function 2: A financial system provides a mechanism
business firms.
for the pooling of funds to undertake
For a variety of reasons-including differences in size,
large-scale indivisible enterprise.
complexity, and available technology, as well as differences
Function 3: A financial system provides a way to
in political, cultural, and historical backgrounds-the most
transfer economic resources through
efficient institutional structure for fulfilling the functions of
time and across geographic regions
the financial system generally changes over time and differs
and industries.
across geopolitical subdivisions. Moreover, even when the
Function 4: A financial system provides a way to corporate identities of institutions are the same, the functions
manage uncertainty and control risk. they perform often differ dramatically. For example, banks
Function 5: A financial system provides price in the United States in 1995 are very different from what they
information that helps coordinate were in 1925 or in 1955, just as they are very different from
decentralized decision-making in the institutions called banks in Germany or the United
various sectors of the economy. Kingdom today. The financial markets in New York,
Function 6: A financial system provides a way to London, or Tokyo today are different from what they were
deal with the asymmetric-information as recently as 1980-before the widespread introduction of
and incentive problems when one trading in fixed-income and stock-index futures, options, and
party to a financial transaction has swap contracts.
information that the other party does not. In contrast, the basic functions of a financial system are
Creditworthiness or default risk is a critical issue for essentially the same in all economies-past and present,
all business firms-and for households as well. East and West. And because the functions of the financial
system
However, for financial intermediaries with are far more stable than the identity and
principal
structure
businesses that involve issuing contingent-payment of the institutions performing them, a functional
contracts to their customers, creditworthinessperspective provides a more reliable and enduring frame of
is the central
reference
financial issue. The prospect of a future default bythan
an an institutional one, especially in a
financial
intermediary on contracts to its customers can environment characterized by rapid changes. Given
significantly
reduce the ex ante efficiency of those contractsthe
andconsiderable
thereby institutional diversity across national
borders,
substantially reduce the effectiveness of the main a functional perspective is more readily adaptable
economic
to
function served by the intermediary. In contrast,a global setting
thefor the financial system. Indeed, with the
current
possibility of default on investor-held debt of rate of technological advance and integration of
a typical
business firm may have little or no impact on the markets, this approach may prove especially
world financial
usefuleconomic
effectiveness of that firm in serving its principal in predicting the future direction of financial
innovation, changes
function. To distinguish between those two situations, the in financial markets and intermediaries,
difference between the "customers" and "investors" of the and the places for regulatory bottlenecks.
firm is developed as a core concept in Section III.

With this general background on the functional
That many of the important businesses run by financial perspective, we turn now to the dynamics of institutional
intermediaries are considerably more "credit-sensitive" than change.
most of those run by non-financial firmnns is a critical element
that distinguishes the important design and management I. On the Future of Financial
Intermediaries: Dynamics of
2Crane, Froot, Mason, Perold, Merton, Bodie, Sirri, and Tufano (1995)
Institutional Change
provides an expanded development with six chapters devoted to illustrating
each of these six functions. Alternative breakdowns of financial functions
are presented in Hubbard (1994), Kohn (1994), Rose (1994), and
One need only consider financial innovation over the
Sanford (1993). past 20 years to underscore the point that while the functions

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MERTON / A FUNCTIONAL PERSPECTIVE OF FINANCIAL INTERMEDIATION 25
Table 1. Classification of Financial Institutions
Transparent Translucent Opaque

Govt. Bond Stock Futures & Unit Trusts Mutual Pension Finance Insurance Commercial
Market Market Options Funds Funds Companies Companies Banks
Markets
of the financial system are stable, the ways in which By way of examples, the development of liquid markets
they are performed are not. Those two decades have seen for money instruments, such as commercial paper, allowed
revolutionary changes in the structure of the world'sthe money-market mutual fund (" transparent institution") to
financial markets and institutions and in our understandingmake major inroads as a substitute institutional structure for
of how to use them to provide households and firms with newbank and thrift ("opaque institutions") demand deposits.
investment opportunities and ways of managing risk.3 For aFinancial futures on equities' indices are an efficient
brief sampling, consider round-the-clock trading fromalternative to market- and sector-index mutual funds. The
Tokyo-to-London-to-New York, financial futures, swaps, creation of "junk-bond" and medium-term note markets
exchange-traded options, mortgage-backed securities,made it possible for mutual funds, pension funds, and
"junk" bonds, shelf-registration, electric funds transfer andindividual investors to service those corporate issuers who
security trading, automated teller machines, NOW accounts,had historically depended on banks as their source of debt
asset-based financing, LBO, MBO, and all the otherfinancing. Similarly, the creation of a national mortgage
acronymic approaches to corporate restructuring. Those market allowed mutual funds and pension funds to
changes in the structure of the financial system came aboutbecome major funding alternatives to thrift institutions for
in part because of a wide array of newly designed securities,residential mortgages. Creation of these funding markets
in part because of the advances in computer and also made entry possible by agent-type institutions (e.g.,
telecommunications technology that made possible theinvestment banks and mortgage brokers) to compete with
implementation of large-volume trading strategies in thesetraditional principal-type intermediaries for the origination
diverse securities, and in part because of important advancesand servicing fees on loans and mortgages.
in the theory of finance.4 Each of these has contributed to The process of" securitization" is essentially the removal
vastly reduced costs of financial transactions. of (non-traded) assets from a financial intermediary's
Greatly reduced trading costs would be expected to causebalance sheet by packaging them in a convenient form and
transaction volume in financial markets to rise substantially, selling the packaged securities in a financial market. This
which it has.5 But, these reductions in costs more generallyprocess of reducing the total size of assets or
have contributed to an even greater expansion in markets"footings" of intermediaries and transferring them to
through the process of "commodization" in which markets is already widespread for mortgages, auto loans,
financial markets replace financial intermediaries as the credit-card receivables, and leases on consumer and producer
institutional structure for performing certain functions. In durables. Now established as a legitimate process, its
terms of an "extended" Ross (1989) classification of application to other types of intermediary assets is likely to
financial institutions (see Table 1), there appears to be a move forward even more rapidly than in the past.6
secular pattern away from opaque institutions toward As a last example, consider a case that has not as yet
transparent institutions. happened, but could: an options alternative to
municipal-bond insurance. In the United States, there are
3As Miller (1992, p. 4) describes it, "No 20-year period in financial historyspecialized insurance companies that sell insurance
has witnessed an even remotely comparable burst of innovative activity."
guaranteeing interest and principal payments on municipal
4Perhaps in no other branch of economics has the implementation of theory
into real-world practice been as rapid as for finance theory and the
bonds against default by the issuer. The policies are typically
sold
financial-services industry over this period. See Bernstein (1992) for an to the issuer municipality, which "attaches" them
in-depth description of this interplay between theory and practice in bringing
to the bonds to give them an AAA credit rating. Consider as
about some of the major innovations of the last few decades.
5For example, the trading volume on the New York Stock Exchange runs
about 150-200 million shares a day, which is 12-15 times the volume of 20 6See Cushman (1993) on the possibility of creating a national market for
years ago. The Exchange claims to have the technology to handle a 1-billion mid-market corporate bank loans. For a comprehensive discussion of the
share day. Note: These figures overstate the increase in transaction capacity
implementation of asset securitization, see Norton and Spellman (1991),
because the number of shares traded per transaction has increased
Zweig (1989), and the entire Fall 1988 issue of Journal ofApplied Corporate
significantly over this period. Finance.

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a competing exclusive
alternative that focus on the
an options ex
market for put options
lead on municipal
to biased bond
forecasts,
then achieve the same
secularloss protection
decline in the im
" uninsured" municipal bond
respect and
to a
the put opti
general
Note that both structures
markets and intermediaries. serve the sa
Financial
investors-protection markets, as we know,
against losstend to be efficient
from de
the institutions areinstitutional
entirely alternatives to intermediaries
different-an when the
is not an insuranceproducts
company, and
have standardized terms, most
can serve e
a large number
even of customers,
intermediaries.8 and are well-enough "understood"
Furthermore, the put for
the exchange is a transactors to be comfortabledifferent
fundamentally in assessing their prices
p
insurance As we also
guarantee. know, intermediaries are better suitedalthou
Nevertheless, for
and the institutions low-volume
thatproducts. Some of these products
provide them will always
are q
economic function they serve
have low volume is arethe
either because they same.
highly customized
This is hardly the or because of for
place fundamental
a information asymmetries.
cost-benefit
competing ways Others,performing
for however, have low volume only because
the they arespec
of municipal-bond new. Among those, the
default "successes" are expected to
guarantees. To
on inter-institutional competition,
migrate from it
intermediaries to markets. That is, once theysuf
the "unbundling" are
of "seasoned,"
the and perhaps after some information pro
down-side
possibility that an asymmetries are resolved,
options those products are structured
exchange with to
collateral and a clearing
trade in a market. Just corporation
as venture-capital intermediaries that co
provide financing for start-up
credit" than an insurance firms expect to lose their pr
company
potential reasons whysuccessful customers to capital-market
issuers and sources of funding,
investors
financial-market so do the intermediaries
structure for guaranteeing that create new financial products.
of the bonds over the Especially in periods with a high intensity one.
intermediary of financial
As these examples innovation,
indicate, there is a large volume of new products created,
intermediarie
compete and therefore, one expects
to be the provider of a large number of instances of pr
financial
technology and theproduct migration from intermediariesdecline
continuing to markets. Following in
has the time path of individual
added
intensity to of products
the that can thus lead to the belief
competi
that as technology continues
Finnerty's (1988 and 1992) extensive histor to evolve, trading markets for
standardized instruments,
financial products suggests a pattern in w such as securitized loans, will
offered initially ultimately
by replace financial intermediaries, such as banks.ult
intermediaries
markets. This For intermediaries
temporal that are rigidly attached
pattern may to a specificseem
financial product or class of products
intermediaries that may indeed be the opa
(especially,
banks) decliningcasein
but not importance
are for intermediation generally. Intermediaries,
and in are
addition to their
institutionally by financial markets.10manifest function of offering custom P
products and services, serve an important latent function of
creating and testing
7With a standard fixed exercise price, the put would actually provide more new products as a part of the general
protection because it covers losses in the value of the bond for any reason,
financial-innovation process.
not just issuer default. However, the coverage could effectively be
"narrowed" to only default risk by making the exercise price "float" to
This dynamic product-development interaction between
equal the current price of an AAA bond with comparable terms to thoseintermediaries
of and markets can be interpreted as part of a
the covered bond.
" financial-innovation spiral" pushing the financial system
8For example, the New York Stock Exchange. However, options (and
futures) exchanges do provide credit intermediation services because they
toward an idealized target of full efficiency.11 That is,
as products such as futures, options, swaps, and
guarantee contract performance for the life of the contract through their
clearing facilities. securitized loans become standardized and move from
9That is, to give each individual investor the choice whether to purchase theintermediaries to markets, the proliferation of new
particular municipal bonds with or without default insurance and to give the
trading markets in those instruments makes feasible the
issuer a way to price-discriminate among investors with differing
assessments of default risk.
dominant source of external finance in all countries" (p. 313). See also
1?This proposition is focused on the change, not the level, of relative
Gorton and Pennacchi (1992) on the changing institutional structure for
importance between intermediaries and markets. It is thus consistent with
serving the depository and lending functions.
Keeley (1990) who reports that bank stocks have been losing market value
llSee Merton (1989, 1990, 1992a, and 1992b) for further discussion.
for the past 20 years and Mayer (1990) who observes that "Banks are the

129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
creation of new custom-designedcontracts were created

financial on various stock
products that indexes, both
improve "market completeness." domestic
To hedgeand foreign.
their These exchange-traded contracts
exposures
further
on those products, the producers, reduced costs,
financial improved domestic diversification,
intermediaries,
and provided
trade in these new markets and volume expanded opportunities
expands; increased for international
volume reduces marginal transaction costs
diversification. and
Moreover, thesethereby
contracts gave the investor
makes possible further implementation
greater flexibility forof more
selecting leveragenew
and controlling risk.
In particular,
products and trading strategies by index futures made
intermediaries, feasiblein
which the creation of
turn leads to still more volume. exchange-traded
Success of these
options trading
on diversified portfolios.14 Recent
further innovations
markets and custom products encourages that serve the diversification
investment in function
have intermediaries
creating additional markets and products, and using
so equity-return
on it goes, swaps to create
spiraling toward the theoretically
custom limiting case of
contracts with individual zero of the stock
specification
marginal transactions costs and dynamically-complete
index, the investment time horizon, and even the currency
markets. mix for payments.15 Thus, the institutional providers of
the stock-diversification
For an example, consider the Eurodollar futures function for households were
market
that provides organized trading in standardized
markets; LIBOR
then intermediaries; then markets again; and then
(London Interbank Offered Rate) intermediaries
deposits at various dates in
again.
As these
the future. The opportunity to trade examples
in this suggest, following
futures market the time path of a
provides financial intermediaries particular
with afinancial
way function
to hedgeinsteadmore
of a product leads to our
efficiently custom-contracted interest-rate
identifying a veryswaps
differentbased on
pattern of a
competition between
floating rate linked to LIBOR.12 A LIBOR rather
intermediaries than
and markets. a of
Instead U.S.
a secular trend away
fromsuited
Treasury rate-based swap is better intermediaries towards
to the markets,
needs ofit is seen as more
many intermediaries' customers because their
cyclical-moving back cash-market
and forth between the two. Table 2
borrowing rate is typically linked tothe
illustrates LIBOR and
generic time not
pattern to
for the institutional
providers
Treasury rates. At the same time, the hugeof a volume
given financial function to households and
generated
by intermediaries hedging their swaps
nonfinancial hasIn helped
firms. make
this hypothetical example, households
the Eurodollar futures market are a great financial success
served initially (at Time 0) by intermediaries using
for its organizers.13 Furthermore, swaps
Product #1. In with
the next relatively
period, Product #1 migrates to a
standardized terms have recently market,
begunand to move are
households from being
now served by that market.
custom contracts to ones traded inWithmarkets. The
the opportunity trading
to trade Productof #1 in a market,
these so-called "pure vanilla" swaps in a market
intermediaries further
can then innovate to create a new product that
expands the opportunity structure better
for performs for householdsto
intermediaries andhedge
firms than the function
provided
and thereby enables them to create by Product #1. Hence, with
more-customized swapsthe introduction of
Product #2 at Time
and related financial products more efficiently. 2, households and nonfinancial firms are
For a second example, consider once
the financial
again functionFollowing the pattern
served by intermediaries.
of providing a well-diversified portfolio of equities
of the financial-innovation spiral,for
the process repeats itself
individual investors. At one time,
withthis function
Product #2 migrating was best the subsequent
to a market,
served by buying shares on a stock exchange.
creation of Product #3 andHowever,
so on. Thus, although products
transactions and monitoring costs
tendas well
to move as problems
secularly of
from intermediaries to markets, the
indivisibilities significantly providers
limited thefunction
of a given number of
tend to oscillate according to
companies that could be held in
the almost anyand
product-migration investor's
development cycle.
portfolio. The innovation of pooling intermediaries,
It is such asof this dynamic
evident from further inspection
mutual funds, greatly reduced those costs,
interaction provided
that intermediaries help for
markets grow by creating
almost perfect divisibility, and thereby
the productsallowed individual
that form the basis for new markets and by
investors to achieve vastly better diversified portfolios, such
as the 500-stock, market-value weighted portfolio of the
14As in the Eurodollar futures/swap example, the availability of index
Standard and Poor's 500 Index. Subsequently,
futures futures
and options markets allows intermediaries to better hedge their
exposures on the products they create.
15See Perold (1992) for a detailed case study on enhanced index equity
12See "Global Debt Monitor: Swap Players Welcome Eurodollar Gold,"
International Financing Review, Issue 934, (June 20, 1992).
products. As shown there, contracts are also tailored to individual tax and
regulatory circumstances. Litzenberger (1992) discusses such tailoring for
13See, for example, Antilla (1992) on the Chicago Mercantile Exchange.
fixed-income products.

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Table 2. Institutional Dynamics for the P

Non-Financial Firms: Intermediaries versus Markets
TIME 0 TIME 1 TIME 2 TIME 3 TIME 4
Product #1
Producer INT MKT MKT MKT MKT
Customer HH/F HH/F INT INT INT
Product #2
Producer INT MKT MKT
Customer HH/F HH/F INT
Product #3
Producer INT
Customer HH/F
Producers Serving INT MKT INT MKT INT

HH/F
HH/F = Households and Non-Financial Firms

INT = Financial Intermediaries
MKT = Financial Markets
design
adding to trading volume in existing ones. In is typically
turn, a new financial instrument (or
markets
help intermediaries to innovate new more-customized
set of instruments), but it can also be an entirely
new
products by lowering the cost of producing financial intermediary.
them. In sum,
financial markets and intermediaries are surely competing
3. Production: producing the new instrument either
institutions when viewed from the static perspective of a
by underwriting both sides of the transaction
particular product activity. However, when viewed from the
(agent) or by synthesizing it through a dynamic
dynamic perspective of the evolving financial system, the
trading strategy (principal), or by a combination
two are just as surely complementary institutions,
of both. each
reinforcing and improving the other in the performance of
their functions. 4. Pricing: determining the cost of production and
profit margin.
II. Financial Engineering and the

5. Customization: further tailoring the instrument
Production Process for to the specific needs of each customer. In most
cases, the problem addressed is relevant to
Financial Intermediaries more than one client. A cost-benefit tradeoff is
Financial engineering is the means for implementing considered in deciding whether to make detail
financial innovation. It is a systematic approach used by changes to fit each individual more precisely.
financial-service firms to find better solutions to specific
The changes in finance theory and computer technology
financial problems of their customers. The process of
in the last decade and the transaction-cost-reducing effect of
financial engineering for intermediaries can be usefully
the financial-innovation spiral have had their greatest impact
broken down into five steps:
on the production part of intermediaries' financial
1. Diagnosis: identifying the nature and source of
engineering process. To model the production process for a
the problem. generic intermediary, I consider two polar models, the
2. Analysis: finding the best solution to the problem "underwriting" and the " synthesizing" models, recognizing
in light of the current state of regulation, that most real-world intermediaries pursue combinations of
technology, and finance theory. The best-solution the two. Instead of developing these basic approaches to

129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
Figure 1. Future Possible Prices of XYZ Stock
Year 0: $100
Year 1: $90 or $115
Year 2: $70 or $110 $90 or $140
production in theprefers. During the interim period,

abstract, the Class A holder
I present t
simple, receives all cashexample.16
hypothetical dividends paid on the XYZ shares and
dictates a
Suppose that as how the shares in the trust are voted.
result of Class Btakin
is a
analysis steps in the
"residual" security that financial
receives whatever assets remain in en
intermediary the Trust, after the Class A claim
determines that has been met.18
a custo
best solved if it Based on the intermediary's
could ownknowledge of the
the price
econo
shares of XYZ process for XYZ, the contingent payoffs
Corporation and to the Trust
haveand each t
insured so that at of its liabilitiesend
the are displayedof
in Table 3.
twoBy inspectionyears,
of that
of $100,000 ($100/share),
table, the Class A instrument has which is al
the identical payoff pattern
the stock.Thus, toone
the insured-equity
"unit"product. However, of
the structure of the
this "
has a contingent Trust guarantees that the promised
payoff payments can be made
structure eq
the without$100
stock price or making any distributional
perassumptionsshare about XYZ,at i
years. 17
because the UST bills are sufficient to meet the minimal
Suppose further that the intermediary knows that XYZ $100,000 payment even if the XYZ shares become
stock will sell for either $90 or $115 a share in a year's time. worthless. Thus, once the Trust is created, the intermediary
If the former occurs, then the stock will either decline further can meet its customer's objective by selling it the Class A
to $70 a share or rebound to $110 at the end of Year 2. If, instrument without having to convince the customer to agree
with its stock-return assessments on XYZ.
instead the stock is $115 at the end of the first year, then it
will sell for either $90 or $140 at the end of the second year. The cost of funding the Trust is $190,700 (=$100,000 for
The intermediary also knows that XYZ will pay no dividends 1,000 shares of XYZ plus $90,700 for $100,000 face value
during this time. A tree diagram of the process is presented of two-year UST bills discounted at 5% per year). Thus, to
in Figure 1. The riskless interest rate is constant over time at make a profit, the intermediary must receive at least
5% per year. $190,700 from the sale of the Class A and Class B units plus
One approach to producing the product is to create a unit cover any other expenses of forming the Trust. The
trust (call it "XYZ Trust") with assets of 1,000 shares of intermediary may have to commit some capital to fund the
XYZ and two-year U.S. Treasury bills with a face value of Trust while it is selling the units, but once they are sold, the
$100,000. The trust has two classes of liabilities: Class A and intermediary has neither capital nor risk exposure to the
transaction.
Class B. Class A is entitled to receive at the end of Year 2
either 1,000 shares of XYZ or $100,000, whichever its owner This approach is essentially a ("buyer-driven")
underwriting activity, and it emphasizes marketing or
distribution
16A development of these production models in a more formal context with skills. As with underwriting in general, the
the mathematics included is presented in Merton (1989, pp. 237-242;
intermediary is positioned more like an agent than a principal
247-253 and 1992b, pp. 441-50; 457-465). General overviews on financial
engineering and its implementation can be found in Eckl, Robinson, and
to the transaction. In terms of product creation, it exemplifies
Thomas (1990), Marshall and Bansal (1992), Mason, Merton, Perold, and
Tufano (1995), and Smith and Smithson (1990).
18Although the example focuses on an equity product, this approach is
17This product is equivalent to a "protective-put" option strategy wherewidely
the used to produce tailored fixed-income products, often with many
investor buys the stock and a put option on the stock. Chase Manhattan more
Bank, than just two classes of liabilities. Indeed, the "residual" security
which issues the product based on the Standard & Poor's 500 Stock Index
always is called the " Class Z" security even if there are fewer than 25 other
in the U.S., calls it a "market-index certificate of deposit." Swissclasses.
Bank Characteristics of the Class A security are designed to meet specific
Corporation uses the name "guarantee-return-on-investment securities"
duration, credit-risk, regulatory, and tax clienteles. Examples are
(GROIS), and Merrill Lynch calls its version "Market Index Targetcollateralized
Term mortgage obligations (CMOs) and collateralized bond
Securities" (MITTS). Leland, O'Brien, and Rubinstein offer the "Super
obligations (CBOs) that use mortgages, bonds, and other fixed-income
Trust" and "Super Shares." assets in the trust.

129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
Table 3. Contingent Payoffs at Year 2
XYZ Stock Price ($) "Class A" Insured Equity ($) "Class B" Residual Claim ($) XYZ Trust ($)
70 100,000 70,000 170,000
90 100,000 90,000 190,000

110 110,000 100,000 210,000
140 140,000 100,000 240,000
the Ross (1989) "marketing"

more valuable than one of correspondingtheory
size filled instead o
unit trust used aswiththe
"customer" names.
intermediation
institution. No sophisticated
An alternative to this "Rolodex" methodstock-e
of production
skills are through
needed, underwriting operating
since is for the intermediary to act asthe
a
one-time principal
purchase of and issue the desired insured-equity
1,000 shares productof
value of UST bills. And
directly knowledge
to the customer as a contractual obligation of the of
distribution (as in
intermediary
Figure (instead of a separate
1)trust).
is In principle,
also the n
Because the structure of the Class A units is derived as a intermediary could do so by buying the same combination of
XYZ stock and UST bill assets held in the Trust in the
direct solution to a specific problem faced by an identified
(class of) customer, one expects that the placement of those
underwriting approach and finance the difference between
units is a relatively "easy" sale. However, to create the
the cost of those assets and the proceeds from sale of the
desired equity-insurance product in this fashion, it is also
insured-equity product with equity capital. This strategy
necessary to sell the Class B units. Because they are the would be almost equivalent to the intermediary creating
residual claims, their payoff structure is not explicitly the Trust and buying the Class B piece itself.21
designed to fit any particular investor group's "desired However, as we know from the work of Grossman and Hart
habitat." 19 Thus, these units must be sold on the basis (1982), Jensen (1986), and others, there are potentially
of price (i.e., as an investment "bargain") and not on thesignificant agency and tax costs associated with the equity
basis of convenience or performance in meeting some capital of firms. Those "dead-weight" costs make equity
finance "expensive" and thereby limit the amount of equity
explicit customer objective. Therefore, to be successful, the
intermediary must charge a sufficient price "premium" that a value-maximizing intermediary would optimally
(over cost) on the Class A units to offset the price "discount"issue.22 Hence, this simple way of combining the
on the Class B units necessary to induce "bargain-hunting"
underwriting intermediary with its bargain-hunting investors
investors to buy them. may not be efficient.
It is evident that an intermediary with a larger number of An alternative that potentially "economizes" on the
contacts with price-sensitive investors is more likely to findamount of capital required is the "synthesizing" or
"dynamic-trading" approach to production. It substitutes a
those who will pay a higher price for the deal.20 Customers
are always looking for "good" products, and financialstrong trading facility for a strong distribution system, and it
relies on the power of modern computer technology and
product designs cannot be patented. The least-cost producer
highly-skilled personnel, trained in advanced methods of
of these products is therefore likely to have an important
advantage. Hence, to intermediaries that produce productsestimation and contingent-claims pricing.23 With its
by this "underwriting" approach, a "fat" Rolodex file
containing names of "bargain-investor" contacts may be21There are some potentially important credit-risk differences between the
two, depending on details of the structuring.
22Otherwise, as we discuss in more detail in the next section, intermediaries
with liability obligations to its customers would optimally guarantee
19In a buyout or takeover with major revisions of a firm's capital structure,
the residual non-equity securities issued are often called "cram-downs,"
performance on those obligations by holding huge positions in liquid assets
reflecting the lack of a natural investor-demand for their pattern offinanced
payoffs.entirely by equity capital.
The payoffs to the Class B units here happen to have the same structure as
23From the descriptions in Loomis (1992), Picker (1992), and Sanford
a two-year, zero-coupon "junk" bond (see Merton 1990, pp. 272-285).
(1993), it appears that Bankers Trust Company provides a real-world
20Such an intermediary would also have the opportunity to "spread" theof this approach to production. See Overdahl and Schachter (1995)
example
trades out with a lower quantity (and possibly higher price) per investor.
on the legal risks of this approach.

129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
Theapproach
reliance on trading, the synthesizing process of synthesizing customer financial contracts
to production
benefits disproportionately fromand securities
the is for financial intermediaries what the
financial-innovation
spiral discussed in Section I. assembly-line production process is for the manufacturing
sector.
There is an enormous academic and The trading-strategy
practitioner rules are the "blueprints" for
literature
production.
on the mathematics and economics The traded securities (XYZ shares and UST
of contingent-claims
pricing and dynamic replication.24 There
bills) used is no are
in the portfolio need to"inputs" applied in
the raw
develop it once again here. It isprescribed
enough to describe
combinations over timethe
to create a "finished"
product or
principles and then illustrate the process "output,"
for my which is a complete set of contingent
hypothetical
example. payments matched to the ones promised on the customer's
The process of implementation is as follows: Once the contract.
specification of the terms of the customer liability to be Compared with the underwriting approach to production,
issued is determined by the capital-markets or the synthesizing approach appears to have several
corporate-finance group of the intermediary, the
advantages: It makes the part of the transaction seen by the
customer easier for the customer because the intermediary
quantitative-analysis group uses contingent-claims analysis
to design a dynamic trading strategy in securitiessimply to issues the contract without requiring the intervening
element of the trust as "another institution" involved in the
synthesize (replicate) the payoff structure of the customer
transaction. The synthesizing method is considerably more
obligation in the least-cost way.25 In the trading operations
(often called a "trading desk") of the intermediary, efficient
a for an intermediary that specializes in unique or
"dedicated" portfolio is established with an initial "one-off' contracts. Essentially, any contract with payoffs
investment equal to the minimum amount necessary to that depend on the price of XYZ stock can be produced by
the same type of process described in Table 4.27 Only the
ensure full implementation of the strategy with no further
mixing rules for adjusting the stock-bills positions are
capital infusions. The trading strategy is dynamic in the
changed. Thus, by analogy with numerically controlled
sense that it typically calls for the composition of the
machines on a physical assembly line, the intermediary need
portfolio to be revised in response to changes in security
only change the "dials" (mixing rules) to have the same line
prices and the passage of time. The trading desk is charged
produce a different output. This approach thus offers the
with implementation of the strategy.
opportunity to create custom-tailored financial products at a
Table 4 illustrates the trading process for this hypothetical
("assembly-line") standard-product level of cost. Another
example with the return dynamics of XYZ stock described
advantage to the intermediary operating as a principal is the
in Figure 1.26 This cookbook-like prescription calls for an
opportunity to "net" its transactions. Thus, an intermediary
initial investment in XYZ stock and UST bills of $106,315.
that offers a wide variety of customer contracts, each
If the price of XYZ rises, more shares are purchased by contingent in different ways on the price path of XYZ stock,
selling bills, and if it falls, the share position is reduced, and can run a single replicating portfolio in XYZ stock and bills
the proceeds are placed in bills. At Year 2, the value of the that hedges the net (aggregate of all customer exposures)
portfolio is equal to the maximum of the value of 1,000 contingent payouts.
shares of XYZ or $100,000. Hence, the portfolio exactly All this does not imply that the synthesizing approach
replicates the contractual payoffs that the intermediary has dominates the underwriting one. Compensation for
promised to its customer. Since the portfolio never requires highly-skilled technical and trading employees and the
a further infusion of capital, the initial investment ofhigh cost of the supporting technology (e.g., super
$106,315 to fund the portfolio is the production cost to the computers) can make the cost of running the synthesizing
intermediary for the product. production system greater than the underwriting system.
Moreover, as principal, the intermediary (its employees
24See Merton (1992b) for a recent and extensive bibliography. and shareholders) bears the risk of errors in production:
These
25There are often multiple ways to implement the strategy that are equivalent errors range from a clerk punching in 11 million
in a frictionless environment, but when transactions costs including market
shares rather than dollars in translating the model
impact from trading, taxes, regulation, and modeling error are taken into
prescriptions
account, they are no longer equivalent. The offset of customer exposures by into orders for execution28 to fundamental
netting of the intermediary's positions and hedging only the systematic
components of the portfolio risks for the intermediary may also be optimal
when there are costs. See Merton (1989, pp. 242-247 and 1992b, pp.Merton, op. cit., for the trading rules for a general payoff function
27See
450-457) for further discussion of those issues. when the dynamics for XYZ stock are as in Figure 1 here.
26The derivation of the synthesizing trading rules for the particular example
28As reported in the press, this actually happened in the case of stock-index
here is presented in Merton (1992b, pp. 337-341; 438-439). arbitrage activities at Salomon Brothers in March 1992.

129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
flaws in the institution. Therefore, of

assumptions principal-type
the intermediaries
model will it
at the end of Year in
2, general
XYZhave to raiseshares
additional assurance are
capital to sellin
a share, despite these being
provide the functional "impossible"
equivalent of the Class B units in the
to the model agent-underwriting alternative.
description of the Which of theprocess
two (or some in
Perhaps the most important
combination) issue
is the more efficient production process will su
effectiveness of an
depend onintermediary
the detailed structure of the transactions and the actin
customer perception
nature of of the intermediar
asymmetric-information and agency costs.30
This is the topic of Section III, and so, I o
a key factor III. Risk Control:
the Ain Major
relativeassessing
costs o
and Managerial Issue for Financial
underwriting approaches is the am
"assurance" or "risk"Intermediaries
capital required by
customer concern about contract perf
Section I concluded that financial intermediaries are the
intermediary.
In constructing the Trust in my hypothetical example, a main functional providers of the "most-finished" type of
total of $190,700 was required to purchase the funding financial products and that technology and competition are
assets. If the $106,315 production cost by synthesis is the constantly driving those products toward ever greater
customization. Section II concluded that between the two
marginal cost of producing the Class A units for the Trust, it
follows that the cost of producing the Class B units is $84,385 basic approaches to production, the synthesizing one (with
($190,700-106,315). In the presence of competition among the intermediary as principal) is generally superior for
intermediaries, it is reasonable to expect that the prices custom contracting, provided that the intermediary can find
received from issuing those securities will not differ greatly a cost-effective way to assure its customers of its ability to
from their respective marginal costs. meet its contractual obligations. This section specifically
Once the Trust is funded, customer holders of the Class addresses the issue of creditworthiness and risk control at the
level of the firm.
A units can be absolutely assured of having the contractual
obligations of the Trust met. So the amount of capital Credit risk or more precisely the prospect of contract
required to provide this assurance is $84,385.29 Hence, about default by a firm is, of course, a concern to all transactors
44% of the total funds to be raised by the intermediary to with that firm, whatever its business. However, unlike most
create the Trust must come from the "residual" piece sold to firms, the efficiency of the central business activities of many
price-sensitive investors. As already discussed, placing the financial intermediaries depends critically on their customer
residual piece is the "difficult" sale and the size of the liabilities being default-free.
discount required on the Class B units clearly can have a The focus of analysis here is on intermediaries that serve
first-order impact on the profitability of the deal. their principal function by issuing liabilities of a certain
In contrast, an intermediary selecting the synthesizing type to customers and manage their assets to facilitate this
approach only needs $106,315 to fund the internal principal function. A straightforward example is a property
production portfolio. If the insured-equity product is and casualty insurance company that issues customized
sold at above production cost, then the cash flow from insurance contracts to its policyholders and invests almost
sales to customers would seem to rule out the need for the exclusively in securities traded in the capital markets. A
intermediary to raise additional capital. However, this more subtle but major example is an organized
conclusion implicitly assumes: 1) that customers know and derivative-security exchange. Some classify such exchanges
agree with the intermediary's assessment for the XYZ as financial markets, not intermediaries. However, unlike a
stock-price process in Figure 1; 2) that customers believe the typical stock or bond exchange, the financial futures and
intermediary can and will undertake the dynamic strategies
described in Table 4; and 3) that customers believe that 30In the real-world versions of our insured-equity example cited in footnote
the other activities of the intermediary will not lead to 17, the banks and Merrill Lynch used the principal approach, and Super Trust
of Leland, O'Brien, and Rubinstein (LOR) selected the underwriting one.
liens on the assets of the replicating portfolio by other
In the 1980s, LOR, in creating its "portfolio-insurance" version of the
claimholders of the intermediary. These three assumptions insured-equity product, chose a hybrid of these two approaches in which it
are not, of course, robust, especially for an opaque managed a replication portfolio but as agent (not as principal) for its
customers. As a concrete illustration of the complementary relation between
markets and intermediaries, the existence of futures and options markets for
29This measure of capital is closely related to the risk-capital measure
trading the Standard & Poor's 500 Stock Index greatly facilitated the
developed more generally in Merton and Perold (1993). real-world production process for all these firms.

129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
Table 4. Production Technology and Production Cost for Insured-Equity Instru

Replication
At Year 0
$70,400 Buy 704 shares XYZ @ $100/share

$35.915 Short-term cash investment @5%
$106,315 Total Investment
At Year 1
If XYZ share price is $90: Sell 454 shares @ $90/share

Value Before Value After
$63,360 704 shares XYZ @ $90 $22,500 250 shares XYZ @ $90
$37.711 Cash and Interest $7857 1 Cash investment @ 5%
$101,071 $101,071
If XYZ share price is $115: Buy

Value Before Value After
$80,960 704 shares XYZ @ $115 $92,000 800 shares XYZ @ $115
$37.711 Cash and Interest $26,671 Cash investment @ 5%
$118,671 $118,671
At Year 2
If share price of XYZ was $90 at Year 1 and,
If share price of XYZ is $70: $17,500 250 shares of XYZ @ $70/share

$82.500 Cash and Interest
$100,000 Value of Portfolio ($100/share XYZ)

$82,500 Cash and Interest
$110,000 Value of Portfolio ($1 10/share XYZ)
If share price of XYZ was $115 at Year 1 and,



129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
options exchanges serve

beneficiaries withthe
a specifiedfundamenta
cash payment in the event of
function of the insured party's
guaranteeing the death. performance
That function is less efficiently o
on their exchanges. Buyers
performed and
if the contract calls sellers
instead for the death benefito
have the clearing tocorporation of party
be paid in the joint event that the insured the
dies ande
other-as their respective counterparty.
the insurance company is solvent. Even if the insurance T
issues liabilities to both classes of its customers. It company offers an actuarially fair reduction in the price of
would vastly reduce the efficiency of the derivative-security
the insurance to reflect the risk of insolvency, a risk-averse
markets if their customers had to "diversify" against
customer would prefer the policy with the least default risk.
contract-default risk by spreading their otherwise
Indeed, on introspection, I doubt that many real-world
homogeneous transactions across a large number of differentwould consciously agree to accept non-trivial
customers
exchanges. It is therefore absolutely essential thatrisk
default theon a $200,000 life insurance policy in return for
clearing corporation of such exchanges have the highest
a large reduction in the annual premium, say from $400 to
credit-standing with its customers. $300. Such results obtain even in theoretical models in which
To see why creditworthiness is a much larger
theissue for has all of the relevant information necessary to
customer
intermediaries than for firms in general, it is helpful
assesstothe
draw
default risk of the insurer.33
a formal distinction between the "customers" and the
The theoretical counterarguments against this distinction
"investors" of the firm.31 Calling attention to the distinction
assert that the customer may be able to eliminate the effect
between customers and investors of nonfinancial firms is
of this default risk either by trading in the securities of the
rarely necessary because it is generally obvious. Few would
life insurance company ("hedging") or by entering into a
confuse the customer who buys a car from an automobile large number of tiny insurance contracts with many different
firm with the shareholder, lender, or other investor who buys
companies ("diversification"). Such a case can perhaps be
its securities. Similarly, no one would confuse a customer
made for frictionless, complete-market economies. But, the
who charges money at a bank or takes out a loan from very economic role of the intermediary is to service those
it with an investor who owns shares in the bank. But, the
entities (its customers) who cannot trade efficiently and who
customers of many types of intermediaries receivecannot
a enter contracts costlessly. A major rationale for the
promise of services in the future in return for payments to the
existence of intermediaries is to reduce the costs that
firms now. Financial services of this type such as life households and firms would otherwise incur to manage risks
insurance and retirement annuities usually involve payments
directly by transacting in the financial markets.
to the customer of specified amounts of money, contingent
By contrast, investors in the liabilities issued by an
on events and the passage of time. Those promised future
intermediary (e.g., its stocks or bonds) understand that their
services are liabilities of the firm, both economically and in
returns may be affected by its profits and losses. Indeed, their
the accounting sense. Since investors in the firm also hold its
function (as with the Class B holders in the hypothetical
liabilities, the distinctions between customers and investors
example of Section II) is to allow the intermediary to better
is not always so clear for such intermediaries.
serve its customers by shifting the burden of the risk-bearing
The distinction between customers and investors can
and resource commitment from customers to investors.
however be made. Customers who hold the intermediary's
The investors of course expect to be compensated for this
liabilities are identified by their strict preference to have the
service by an appropriate expected return. The resulting
payoffs on their contracts as insensitive as possible to the
increase in efficiency of customer contracts from this shift in
fortunes of the intermediary itself.32 For example, the
risk-bearing makes customers better off. Note that although
function served by a life insurance policy is to provide
theits
functional roles of "customers" and "investors" are
distinct, the same individual or firm can be both a customer
31The customer-investor distinction was first made in Merton (1989) to of and an investor in a particular intermediary. Thus, I can
establish the importance of risk management for financial institutions. The both buy an insurance policy from a particular insurance
discussion here is taken largely and often verbatim from Merton and Bodie
(1992, Section II). company and also hold its shares as part of my investment
32An economy with pure Arrow-Debreu securities provides a formal portfolio.
example of this general point. It is well-known that a complete set of such
securities permits Pareto-efficient allocations. If, however, the payoffs on
such securities were also contingent on the solvency of the issuer of
the securities, then they would lose their efficiency. See Merton (1989, 33In most real-world cases, the customers do not have the relevant
pp. 252-253 and 1992b, pp. 450-1; 463-7) for a more complete discussion information, and this fact afortiori makes the potential welfare loss from
of this point. customer-contract default even greater.

129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
The distinction between an investor-held and a

an excellent survey article on the increasingly key role
customer-held liability claim is not unique to of
financial
risk management in international banking practice. Rawls
intermediaries. For example, a customer whoand buys a
Smithson (1990) give a compact discussion of risk
warranty on a new car from an automobile manufacturer
management as a strategic tool for firms generally. See also
wants the repairs paid for in the event that the car is Froot, Scharfstein, and Stein (1993) and Hindy (1995).
defective.
In fact, the customer's contract pays for repairs in the joint
There are essentially three ways for an intermediary with
event that the car is defective and the automobile
credit-sensitive activities to provide assurances against
manufacturer is financially solvent. If given a choice,
default risk to the customers who hold its liabilities: 1) By
customers would prefer not to accept additional hedging: the firm holds assets that have payouts that
default risk
in return for an actuarially fair reduction in the"match"
cost of thepromised on its contractual liabilities, and it
those
warranty. Much the same point can be madechooses
abouta "transparent"
the structure so that customers can
implicit contract with customers to ensure that spare parts
easily are
verify that such a matching policy is being followed.35
available in the future for repairs. Although it 2)
canBy become
insuring: the firm acquires guarantees of its customer
quite significant for a financially distressed firm, liabilities from a AAA-credit-rated private-sector or
default risk
is probably a secondary consideration for most customers
government of
third party. The providing of such guarantees is
an automobile manufacturer. In contrast, because of financial-intermediation
a large the business, which is itself
substantial size and long duration of manyquite
financial
credit-sensitive.36 3) By capital cushions: the firm
contracts, such as annuities and life insurance, default risk is capital beyond that required for the funding
raises additional
a first-order issue for customers of financial intermediaries.
of the physical investments and working capital needed to
Thus, the success of a financial intermediary depends not
run the intermediary. Included in this category is the common
only on charging adequate prices to cover its production
practice of collateralizing contract performance, as for
costs but also on providing adequate assurances towith
example, itsrepurchase agreements, futures contracts, and
customers that promised payments will be made.
broker margin loans. The distinction between the collateral
In sum, customers in general are likely to knowapproach and hedging is that the collateral assets are not
less about
the firm's business prospects than its investors. chosen to match the promised payment obligation on the
contract. Assurance capital typically takes the form of
However, the larger cost of customers instead of investors
equity although debt that is subordinated to customer
bearing default risk of the firm is not simply a consequence
of customers being less well-informed than investors. Thecontractual claims can sometimes be used. Equity capital
" wedge" of additional cost between customers and investors
costs can be high because of both its tax disadvantage and
is primarily the result of customers "internalizing" risks of
the agency costs between corporate insiders and external
equityholders.
the firm that investors can eliminate by diversification. That
is, the efficiency of customer contracts is diminished if they Agency costs are the principal economic dead-weight
are exposed to default. The term "credit-sensitive" is used
costs to the intermediary for any of the three ways used to
to describe the businesses of an intermediary that are provide assurance of performance on customer contracts. In
significantly affected by changes in customer perception of Merton (1993, Section 6), a hypothetical example is used to
the credit standing of the intermediary. Business activitiesillustrate the impact of these costs on optimal managerial
that require customers to hold contractual liabilities of the
decisions in intermediaries. That same analysis shows that a
intermediary tend to be credit-sensitive.34 Controlling
passive attempt at diversification or retention of a business
contract default is inexorably connected with *riskthat does not benefit from either the integrated or opaque
management of the intermediary. Freeman (1993) providesstructure of the intermediary reduces the value of the
intermediary.37
34Some intermediaries serve their main function by buying assets of a certain
type from customers. They issue liabilities only to investors to facilitate the35" Transparent" is used here in the sense of Ross (1989), as illustrated in
performance of that main function. For example, consumer financeTable 1. Mutual funds and unit trusts are prime examples of transparent
companies in the United States serve the primary purpose of making loans intermediaries that address customer concerns about contract performance
to their customers, and they raise all of the money that they lend by issuing
by matching assets and liabilities.
securities to investors. There is no first-order customer concern about such
intermediaries' credit risk because the customer owes the intermediary.36See Merton and Bodie (1992) for an in-depth analysis of the management
However, when there are initial costs to the borrower in establishingofa the guarantee business, for both private-sector and government providers.
Cossin (1993) offers an impulse-control model that quantifies the optimal
relationship with a lending intermediary, then even these customers will
exhibit credit-sensitivity (see Selz, 1992). Intermediaries, such asmanagement of the guarantee business.
commercial banks and thrifts in the United States, that service customers on
37This result is consistent with the Ross (1989) model of financial innovation
both sides of their balance sheets, are credit-sensitive. and intermediation.

129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
A key requirementfrequently
for have the success
significant unanticipatedof any
and unintended
intermediary is its ability
consequences forto the control both the
financial-services industry.40
perceived default risk ofAs stated
its at the outset, financial innovation is theliabili
customer-held
customer demand engine
for driving the financial
service and system toward its goal of
greater com
products will intensifygreater
the economic efficiency. Innovation
attention given in financial
to thi
future.38 One intermediation
implication is thatimproves efficiency
the by completing markets,fina
internal
of financial lowering transaction
intermediaries are likelycosts, and reducing
to be agencyexpan
costs.
not only the increased The analyses of the preceding
working capitalsections onneeds
the dynamics of t
also the management ofof institutional
its change and the operational issues of
counterparty cred
Further production
development of this and risk
themecontrol for financial
is far intermediaries
beyond
this paper. But have thus
perhaps the emphasized
brief innovationdiscussion
in products and services. he
to focus attention and stimulate further research on these However, with their focus on product and service
issues of first-order importance to intermediaries involved innovations,
in those analyses do not address innovations
credit-sensitive activities. in the financial "infrastructure"--that is, the institutional
interfaces between intermediaries and financial markets,
IV. Government Regulation and regulatory practices, organization of trading and clearing
facilities, and management information systems.
Financial Intermediation39
But improvements in efficiency from innovative
Promoting competition, ensuring market integrity,
intermediary products and services cannot obtain without the
concurrent changes in the financial infrastructure that are
including systematic or macro credit-risk protections, and
managing "public-good"-type externalities cover the broadnecessary to support those products and services. Indeed,
perhaps the single most important perspective for public
potential roles for regulation and other government activities
in improving the economic performance of financial policy on financial innovation is the explicit recognition of
intermediaries. the interdependence between product and infrastructure
innovations and of the inevitable conflicts that arise between
There are five categories to classify the paths by which
the two.
government affects financial intermediation: first, as a
market participant following the same rules for action as As an analogy of supreme simplicity,41 consider the
other private-sector transactors, such as with open-market creation of a high-speed passenger train, surely a beneficial
product innovation. Suppose however, that the tracks of the
operations; second, as an industry competitor or benefactor
current rail system are inadequate to handle such high speeds.
of innovation, by supporting development or directly
In the absence of policy rules, the innovator, either through
creating new financial products or markets, such as
ignorance or a willingness to take risk, could choose to fully
securitized mortgages, index-linked bonds, or all-savers
implement his product and run the train at high speed. If the
accounts; third, as both legislator and enforcer, setting
rules and restrictions on financial intermediaries and
train subsequently crashes, it is, of course, true that the
innovator and his passenger-clients will pay a dear price. But,
markets, such as minimum-capital rules, asset restrictions,
if in the process, the track is also destroyed, then those, such
disclosure requirements, margin limits, circuit breakers,
as freight operators, who use the system for a different
and patents on products; fourth, as a negotiator when
purpose will also be greatly damaged. Hence, the need for
representing its domestic constituents in dealings with other
policy to safeguard the system. A simple policy that fulfills
sovereigns that involve financial intermediaries or markets;
that objective is to permanently fix a safe but low speed limit.
fifth, as an unwitting intervenor who changes But, general
of course, this narrowly focused policy has the rather
corporate regulations, taxes, and other laws or policies that consequence that the benefits of innovation will
unfortunate
never be realized. An obviously better, if more complex,
38Even now, the explosive growth in custom contractual agreements, such

as long-maturity currency and interest rate swaps, has made derivative 40Their potential benefits notwithstanding, these five categories of
products among the more profitable and more credit-sensitive intermediary government activities also have potential costs including direct costs to
activities. Merrill Lynch, Goldman Sachs, and Salomon Brothers have eachintermediaries, such as legal and registration fees, distortions of prices and
created special-purpose AAA subsidiaries to issue those products and resource allocations, transfers of wealth among private-party participants in
thereby address the credit concerns of customers. See Internationalintermediation, and transfers of wealth from taxpayers to financial
Financing Review (1993) and Cossin (1993). intermediaries.
39This section draws heavily on Merton (1989, 1990, and 1992a). 41This analogy is taken verbatim from Merton (1989, p. 257).

129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
policy solution is to facilitate thebalance

needed restored between
upgrading ofproduct
the demands and
track and, at the same time, to set supporting
transient limits on the
infrastructure, speed,
system was subsequently
while there is a technological imbalance
to handlebetween
efficiently the product
a volume of business much larger
and its infrastructure. that which had caused the original breakdown.
As in this hypothetical rail system, the The back-office problem of 1970 was resolved with
financial-intermediation system is used by many for government
formal a intervention. It is, however, less l
variety of purposes. When treated atomistically, innovations
that such intervention could be avoided today if a prob
in products and services can be implemented by individual
arose of similar magnitude involving security transact
intermediaries unilaterally and rather quickly.
TheSuch
number of competing financial intermediaries
innovations thus take place in an entrepreneurial and
exchanges (including derivative-security exchanges) loc
opportunistic manner. In contrast, innovations in financial
around the globe would make it extraordinarily difficult
infrastructure must be more coordinated and, therefore, takeat private voluntary coordination to succeed.
efforts
longer to implement. As we see, for instance, with Conflicts
thrift between product innovation and the evolut
and banking legislation in the United States in the 1990s,
of infrastructure in the financial-intermediation system
major changes, including outright elimination of inevitable,
obsolete but government actions can do much to ei
institutions and their surrounding regulatory structure, take or aggravate their disruptive effects. By anal
mitigate
place at an exceedingly slow pace. It is thus whollyhurricanes are inevitable, but government policy can ei
unrealistic to expect financial innovation to proceed along a
reduce their devastation by establishing early war
balanced path of development for both the product and
systems or it can aggravate the damage by encouragin
infrastructure components of the intermediary system.
theItbuilding
is of housing in locations that are espec
vulnerable
indeed possible that at times, the imbalance between these to such storms.
two elements could become large enough to jeopardize thegovernment actions can significantly influence the
While
very functioning of the system. Hence, the need for path
policy
of to
development for financial intermediation, successful
protect against such a breakdown. But, as we havepublic
seen,policy
a depends as importantly on recognizing the
single-minded policy focused exclusively on this concern
limitations of what government can do to control and
could derail the engine of innovation and bring to aimprove
halt the
the efficiency of the intermediation system.
financial system's trip to greater efficiency.42 As discussed at the outset, the functional perspective
As an example of a policy that did not unnecessarily
emphasizes the discovery of more efficient ways to perform
inhibit innovation, consider the case of the near-collapse
one or more of the six basic functions of the financial system
of the security-trade processing systems at many as theU.S.
fundamental driving force behind product innovations
brokerage firms during the bull market of 1970. The
and institutional changes in financial intermediation.
technology for processing orders at that timeHowever,
did nota different perspective holds that cost reduction or
allow firms to cope with the large volume of transactions
otherwise lessening the constraints of regulation, including
flowing into their "back offices." Brokerage firms andaccounting rules, is the main force behind financial
taxes and
their customers therefore had incomplete and innovations.
in many Miller (1986), for example, sees frequent and
cases inaccurate information about their financial
unanticipated changes in regulations and tax rules as the
positions. This breakdown eventually caused some ofmotivators
prime those of financial innovation during the last
firms to fail. The problem was temporarily solved without
quarter century. Silber's (1983) view that financial
government intervention through cooperative action
innovation arises from attempts to reduce the cost of various
between the major stock exchanges. For a period of time,
regulatory constraints on businesses is consistent with this
they restricted trading hours to allow firms to perspective
catch up onas is Kane's (1977, 1984, and 1988) theory of
their processing of orders and reconciliation of accounts.
dynamic The
regulation.
problem was finally solved and normal trading patterns
The two perspectives are not in conflict, however, once
resumed after the firms and exchanges made massivein time horizon are taken into account.
differences
investments in new technology for data processing. With thecan have a powerful influence on innovation and
Regulation
the behavior of financial intermediaries in the short run.
However,
42As an example, a range of regulatory reactions and recommendations for regulation both shapes and is shaped by the time
the over-the-counter derivatives markets can be found in Commodity
path of financial innovation. Exogenous changes in
Futures Trading Commission (1993), General Accounting Office (1994),
regulation are surely possible in the short run. But such
and Global Derivatives Study Group (1993). See also Overdahl and
Schachter (1995) and Pard (1994). changes induce responses in financial innovation and

129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
institutional change, which

policymakers inspeculating
are effectively turn againstfeed
a long-run b
dynamics of regulation.43 As
trend of declining a result,
transactions the
costs if they continue to fe
sustainable regulatoryassume that the " traditional"
policies isfrictions within their individual
increasingly e
determined as the time horizon
financial systems lengthens
will allow national governments to pursue
regulatory change monetary
has and a related
limited long-run
financial policies with the same degree
exogenous force for financial innovation
of control as in the past.47 and
Much the same point applies to an no
structural changes in individual
financial intermediation.
nation's fiscal policy, which will surely be further
Both the time horizon that
constrained not justqualifies as the
with respect to transactions and other "lo
this context and the scope of
" targeted" taxes effective
on financial intermediaries and national
markets but
control overfinancialeven
intermediation are
with respect to general income tax rates, likely
both personal
in the and corporate.48
future. Advances in telecommunications an
technology have provided greatly
A functional perspective onincreased flexi
the financial system should
choice of the physical
prove moreand
useful thanjurisdictional
an institutional one in times of l
financial intermediaries
rapid change. and markets.44
This perspective focuses attention on Co
example, the interbank foreign
predicting exchange
the institutional structures that will performmark
the
the largest financial market
intermediation functions most effectively in the future. Co
in the world.45
series of direct electronic
Armed with connections among
these forecasts, government could set policies th
of participating banks and
from around
regulations the
to facilitate the globe,
requisite changes in th
no meaningful physical or
structures instead political
of attempting to protect and locatio
preserve
regulated by any national
existing ones. authority,
Its flexibility with respectand it
to different is
difficult to see how it could be.
institutional environments makes the functional perspective
The technological changes that have already dramatically
on regulation more readily adaptable to a global setting for
reduced transactions and product-marketing costs are likely
financial intermediation, which may be particularly useful if
to make future changes in the institutional forms of
supranational regulatory bodies are to be formed.49
intermediaries even more rapid and far-reaching. With much
A major shift in the format of regulation from
lower transactions costs, it becomes profitable not only to
"institutional" to "functional" seems inevitable.50
introduce new intermediation products but also to change
Increasingly more sophisticated trading technologies (such
entire institutional arrangements (including geographical
as the synthesizing production process of Section II),
and political locations) in response to much smaller changes
together with low-transaction-cost markets to implement
in customer tastes or operating costs than in the past.
them, tend to blur the lines among financial-intermediation
These lower transactions costs, together with the prospect of
even greater global competition in financial-intermediationproducts and services. The existence of these technologies
services, provide the basis for forecasting substantial and markets also implies easier entry into financial
increases in both the frequency and the magnitude of theintermediation. As a result, the institutional lines between
changes in the institutional structure of financial financial intermediaries are also likely to become less
intermediaries. This forecast reduction in the "half-life" or distinct. Indeed, insurance companies now offer U.S.
expected duration of institutional forms applies not only Treasury
to money-market funds with check writing, while as
described in Section II, banks use option and futures-markets
financial-service firms but also to the regulatory bodies that
govern them.
This increasing flexibility and global mobility of financial
47See Wriston (1992) on the failed attempt of European central banks to
institutions have far-reaching implications not only forcoordinate currency values in 1992.
regulation of intermediaries at the national level but for
48See Scholes and Wolfson (1992) for an in-depth development of the theory
national monetary and fiscal policies as well.46 Thus,
and application of financial instruments and alternative institutional designs
to respond to differing tax and regulatory structures. Although always
available in principle, these techniques have a greatly magnified impact in
43This process is the essence of Kane's (1977) regulatory dialectic.
a low-transaction-cost and global environment.
44See, for example, Lingren and Westlund (1990) and Umlauf (1993) on the
49See Grundfest (1990) for analysis and data on the globalization of world
effects of a transactions tax on the location of trading for Swedish stocks
financial markets and its implications for regulation.
and derivative securities.
50See Merton (1995) for further discussion. The Chicago Mercantile
45Estimates are that between $600 billion and $1 trillion is transacted in this
Exchange (1993) has proposed a regulatory structure along functional lines.
market every day.
Some (e.g., Heurtas, 1987) have used the term "functional regulation" to
46Government can also be limited in what it can do because it has too much
mean regulation along product lines. As used here, the term is broadened to
power. See Merton and Bodie (1992, Section V) for discussion and examples
include different products that are (virtually) perfect substitutes from the
of this paradox of power. perspective of their users.

129.67.246.57 on Fri, 21 Jan 2022 18:30:27 UTC
required with the current

transactions to provide stock-and-bond-value institutionally that
insurance based regulatory
guarantees a minimum return on structure.
customer portfolios. Credit
The perceived
subsidiaries of major manufacturing benefitswhich
firms, from a move
onceto functional
regulation
performed the single, specialized functionmight seem to support a broader case for
of providing
widespread
financing for customers of their coordination,
parents, and even
have standardization, of
become
financial regulations,
multiple-function financial institutions with both domestically and across national
intermediation
services ranging from merchantborders.
banking However,
forsuchtakeovers
extrapolation is and
valid only if the
restructurings to general credit coordinated
cards regulatory policies chosen are socially
and equity-indexed
mutual funds sold to retail investors. Inreduction
optimal. The contrast, from
in "regulatory the
diversification" that
by necessity
perspective of the user, the function of a occurs with more effective
financial product coordination
is will
relatively well-defined. accentuate the social losses if the selected common policies
As in the case of the interbankare suboptimal.51exchange market,
foreign
electronics has made problematic the meaning
An important of
and innovative step "the
along this line has
been taken by Most
location of the vendor" of these products. the Basle regulation
Committee (1995)of in its recent
financial intermediaries involvesproposal to set global
products andcapital standards
services for bank
for
household customers and, hence,portfolios
the user's location
of marketable securities.is often
Although the standards
better defined than the vendor's.
areOver
globally time,
uniform, functional
their implementationusesin terms of
capital calculation
of products are typically more stable than the will beinstitutional
based on the individual
internal
forms of their vendors. In keeping risk-management
with the trend modeltoward
of each bank. This
diversifying
greater user access to international financial delegation contrastsproduct
markets, sharply with prior
and service functions appear tocapital-requirement
be more uniform rules that depend on a single capital
across
model specifiedthat
national borders than are the institutions by the provide
regulatory supervisor.
them. Moreover,
Functional regulation also reduces the newtheproposal calls for penalties for
opportunities imposing higher
institutions to engage in "regulatory arbitrage,"
capital requirements on banks withwhich
poorly performing
wastes real resources and can undermine the intent of the risk-management models. Banks thus will have an
regulation. It thus promises more consistent treatment forincentive
all to compete with each other in developing more
effective risk-management systems. It remains to be seen
providers of functionally-equivalent products or services,
how much of this proposal is finally adopted.52 The
thereby reducing opportunities for "rent-seeking" and
international issue of the trade-off between the benefits
"regulatory capture." Furthermore, functional regulation
of regulatory cooperation and the benefits of regulatory
can facilitate necessary changes in institutional structures
competition promises to be among the more important
by not requiring a simultaneous revision of the regulations
or the regulatory bodies surrounding them, as is financial regulatory issues of the 1990s. U
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A Functional Perspective of Financial Intermediation Robert C. Merton

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A Functional Perspective of Financial Intermediation Robert C. Merton

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A Functional Perspective of Financial Intermediation

Author(s): Robert C. Merton

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Financial Management, Vol. 24, No. 2, Summer 1995, pages 23-41.

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From the most

firm is developed as a core concept in Section III.

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Table 1. Classification of Financial Institutions

Transparent Translucent Opaque

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creation of new custom-designedcontracts were created

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Table 2. Institutional Dynamics for the P

TIME 0 TIME 1 TIME 2 TIME 3 TIME 4

Producer INT MKT MKT MKT MKT

Customer HH/F HH/F INT INT INT

Producer INT MKT MKT

Customer HH/F HH/F INT

Producers Serving INT MKT INT MKT INT

HH/F = Households and Non-Financial Firms

MKT = Financial Markets

II. Financial Engineering and the

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Figure 1. Future Possible Prices of XYZ Stock

Year 1: $90 or $115

Year 2: $70 or $110 $90 or $140

production in theprefers. During the interim period,

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Table 3. Contingent Payoffs at Year 2

70 100,000 70,000 170,000

90 100,000 90,000 190,000

the Ross (1989) "marketing"

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flaws in the institution. Therefore, of

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Table 4. Production Technology and Production Cost for Insured-Equity Instru

$70,400 Buy 704 shares XYZ @ $100/share

If XYZ share price is $90: Sell 454 shares @ $90/share

If XYZ share price is $115: Buy

If share price of XYZ was $90 at Year 1 and,

If share price of XYZ is $70: $17,500 250 shares of XYZ @ $70/share

$100,000 Value of Portfolio ($100/share XYZ)

If share price of XYZ is $100: $27,500 250 shares of XYZ @ $110/share

$110,000 Value of Portfolio ($1 10/share XYZ)

If share price of XYZ was $115 at Year 1 and,

If share price of XYZ is $90: $72,000 800 shares of XYZ @ $90/share

$100,000 Value of Portfolio ($90/share XYZ)

If share price of XYZ is $140: $112,000 800 shares of XYZ @ $140/share

$140,000 Value of Portfolio ($140/share XYZ)

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options exchanges serve

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The distinction between an investor-held and a

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38Even now, the explosive growth in custom contractual agreements, such

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policy solution is to facilitate thebalance

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institutional change, which