Customers and Investors: A Framework for Understanding Financial Institutions

Robert C. Merton

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

Richard T. Thakor

Massachusetts Institute of Technology (MIT) – Sloan School of Management

June 1, 2015


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. It further explores the implications of this customer-investor nexus 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 (unexpected) deviations from the ex ante optimal contractual arrangement. We show that the optimality of insulating the customer from the credit risk of the intermediary explains various contractual arrangements, institutions, and regulatory practices observed in practice. 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. Finally, the approach taken here shows that financial crises may be a consequence of observed but unexpected deviations from the ex ante optimal risk-sharing arrangement between financial intermediaries and their customers.

Customers And Investors: A Framework For Understanding Financial Institutions – Introduction

In three papers, Merton (1989, 1993, 1997) introduced the idea that many types of financial intermediaries provide “credit-sensitive” financial services, i.e., the effective delivery of these services depends on the credit-worthiness of the provider.1 The intermediary’s credit standing can generate externalities for the different business activities of the intermediary, even when they are not directly interconnected through common customers or other such elements. A concrete example is an investment bank that expresses an interest in participating in a bridge loan as an attempt to start a merchant banking business and in doing so runs the risk of having institutional customers flee its over-the-counter derivatives business (e.g. long-dated swap contracts) because of concerns about the ability of the bank to fulfill its contractual obligations on its derivative products were it to suffer losses on its bridge loans (see Merton (1997)).2 In various theories of financial intermediation, the raison d’etre of a financial institution is to serve its customers (depositors and borrowers in the case of a bank, for example), so the potential sensitivity of the perceived value of the intermediary’s services to its own credit risk has important implications. Our main goal in this paper is to study how this aspect of the relationship between a financial intermediary and its customers affects the design of contracts between intermediaries and their customers, and how it helps us to better understand commonly-observed features in a wide variety of real-world contracts, institutions, and regulatory practices.

Financial institutions differ from non-financial firms in many significant respects. First, what investors in a financial institution purchase looks very similar to what its customers purchase. For example, investors who buy a bank’s subordinated debt have a financial claim that is similar to the claim of the bank’s depositors in that both are debt claims on the bank’s cash flows. In contrast, customers and investors in non-financial firms look quite different—a customer who buys a General Motors car is transparently different from an investor who buys the company’s bonds. A second distinguishing feature of financial intermediaries is that their assets and liabilities are closely related. For example, in a bank one group of customers— borrowers—provide financing to the bank in the form of deposits (also structured as debt contracts). Thus, the bank has customers with debt contracts on both sides of its balance sheet.

The fact that much of a bank’s assets and liabilities are comprised of forms of debt also contributes to much higher leverage in banks (and other financial institutions) compared to nonfinancial firms. In contrast, in a non-financial firm, assets and liabilities typically appear to be very different. In an automobile company, for instance, the assets are manufacturing plant and equipment and its inventory of cars, whereas liabilities are the money the company has borrowed from investors.

A third important distinction is that in financial institutions both investors and customers provide financing to the intermediary.3 Investors, such as stockholders or bondholders of an intermediary, provide risky financing—they expect the payoffs of their claims to be linked to the intermediary’s outcomes. Included among investors are also external guarantors of an intermediary’s liabilities. Thus, investors provide financing as well as risk-bearing. Customers, on the other hand, expect services in exchange for the financing they provide, but prefer to not have the services they receive depend on the fortunes of the provider of the service.

Here we need to distinguish between two types of customers. “Credit-sensitive” customers provide financing to the intermediary in exchange for the provision of future services by the intermediary. The financing provided by these customers appears as a liability of the intermediary. These customers derive utility from the services the intermediary provides to them, and this utility is diminished by an increase in the credit risk of the intermediary. Other customers are those who receive financing from the intermediary, such as mortgage or other loan borrowers. They appear on the asset side of the intermediary’s balance sheet, are not credit-sensitive since they have an obligation to repay the intermediary in the future.

Financial Institutions

Financial Institutions

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