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  • 2015
  • Working Paper

Customers and Investors: A Framework for Understanding Financial Institutions

By: Robert C. Merton and Robert T. Thakor
  • Format:Print
  • | Language:English
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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. 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.

Keywords

Financial Institutions

Citation

Merton, Robert C., and Robert T. Thakor. "Customers and Investors: A Framework for Understanding Financial Institutions." NBER Working Paper Series, No. 21258, June 2015.
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About The Author

Robert C. Merton

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    No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions

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More from the Authors
  • No-fault Default, Chapter 11 Bankruptcy, and Financial Institutions By: Robert C. Merton and Richard T. Thakor
  • The Crisis in Retirement Planning By: Robert C. Merton
  • Tribute to Paul A. Samuelson By: Robert C. Merton
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