Working Paper: NBER ID: w21258
Authors: Robert C. Merton; Richard T. Thakor
Abstract: Financial institutions have both investors and customers. Investors, such as those who invest in stocks and bonds or private/public-sector guarantors of institutions, expect an appropriate risk-adjusted return in exchange for the financing and risk-bearing that they provide. Customers of a financial intermediary, in contrast, provide financing in exchange for a specific set of services, and do not want the fulfillment of these services to be contingent on the credit risk of the intermediary, even when they are not small, uninformed agents lacking in sophistication. This paper develops a framework that defines the roles of customers and investors in intermediaries, and uses the framework to provide an economic foundation for the aversion to intermediary credit risk on the part of its customers. This customer-investor nexus has implications for a host of issues related to how contracts between financial intermediaries and their customers are structured and how risks are shared between them, as well as the consequences of (unanticipated) deviations from the ex ante efficient contractual arrangement for institutional design, regulatory practices, and financial crises. Moreover, customers and investors are often intertwined in practice, and so this intertwining provides insights into the adoption of “too-big-to-fail” policies and bailouts by regulators in general.
Keywords: financial institutions; customers; investors; credit risk; contract design
JEL Codes: D81; D83; G01; G20; G21; G23; G28; H12; H81
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| credit risk exposure of the intermediary (G21) | utility derived by customers (L97) |
| credit risk exposure of the intermediary (G21) | demand for insulated contracts by customers (G52) |
| credit risk exposure of the intermediary (G21) | loss of economic surplus (D61) |
| intermediaries imposing credit risk on customers (G21) | competitive disadvantage (L19) |
| intertwining of customers and investors (D26) | potential for systemic risk (E44) |