Financial innovation and the management and

JournalofBANKING&FINANCEELSEVIERJournalofBanking&Finance19(1995)461-481FinancialinnovationandthemanagementandregulationoffinancialinstitutionsRobertC.MertonTheHarvardBusinessSchool,Morgan397,SoldiersField,Boston,MA02163,USAAbstractNewsecuritydesigns,improvementsincomputerandtelecommunicationstechnologyandadvancesinthetheoryoffinancehaveledtorevolutionarychangesinthestructureoffinancialmarketsandinstitutions.Thispaperprovidesafunctionalperspectiveonthedynamicsofinstitutionalchangeandusesaseriesofexamplestoillustratethebreadthanddepthofinstitutionalchangethatislikelytooccur.Theseexamplesemphasizetheroleofhedgingversusequitycapitalinmanagingrisk,theneedforriskaccountingandchangesinmethodsforimplementingbothregulatoryandstabilizationpublicpolicy.Keywords:Financialinnovation;Banking;FinanceJELclassification:G2;G31.IntroductionRiskmanagementoffinancialinstitutionsandtheroleofcapitalisarichandtopicalsubjectfromtheperspectivesofbothacademicsandpractitioners.How-ever,myremarksherewillnotfocusoneitherrisk-basedcapitalordepositinsuranceoreventheperformanceoffinancialinstitutions,iAlongthosedimen-sions,itisclearfromtheagendathatweallwillfindourcupsabundantlyfilledonthesetopicsoverthecourseoftheconference.Instead,inthissalutatorysession,Itrymyhandatcreatingaframeofreferenceforwhatistofollowbydescribing1ThedefinitionandmeasurementofriskcapitalanditsdistinctionfromeithercashcapitalorregulatorycapitalisdiscussedinMertonandPerold(1993).0378-4266/95/$09.50©1995ElsevierScienceB.V.AllrightsreservedSSD!0378-4266(94)00133-2462R.C.Merton/JournalofBanking&Finance19(1995)461--481prospectivelysomeofthechangesintheevolvingfinancialsystemandbyaddressingsomesupportingbutpotentiallyfundamentalissuesthatlieunderneaththetopicfocusoftheconference.Letmebeginwithaquestion:Asweallknow,thepasttwentyyearshaveseenrevolutionarychangesinthestructureoftheworld'sfinancialmarketsandinstitutionsandinourunderstandingofhowtousethemtoprovidenewinvestmentopportunitiesandwaysofmanagingrisk.2Thosefinancialinnova-tionscameaboutinpartbecauseofawidearrayofnewsecuritydesigns,inpartbecauseoftheadvancesincomputerandtelecommunicationstechnology,andinpartbecauseofimportantadvancesinthetheoryoffinance.3Whythenistherenowsuchanintensityofconcernamongmanagers,regulators,politicians,andthepressoverthenewactivitiesandrisksoffinancialinstitutions-relativetotheirtraditionalriskssuchasrealestateloansorLDCdebt?Certainly,therehasnotyetbeenamajorfinancialcrisisassociatedwiththesenewactivitiesandinstrumentsofthekindassociatedwithdefaultsbycountriesandthethriftsinthe1970sand1980s.Indeed,aswillbediscussedinSection4,theriseofderivativeproductscouldhavejustaseasilybeenframedasgreatlyreducingrisksinthesysteminsteadofincreasingthem.4Myconjectureastowhythereisthisanxietyorstrongfocusontherisksofthenewactivitiesisthattheirimplementationhasrequiredmajorchangesinthebasicinstitutionalhierarchyandintheinfrastructuretosupportitandthattheknowl-edgebaserequiredtomanagethispartofthesystemissignificantlydifferentfromthetraditionaltrainingandexperienceofmanyprivate-sectorfinancialmanagersaswellasregulators.Changesofthissortarethreatening.Itisdifficulttodealwithchangethatisexogenouswithrespecttoourtraditionalknowledgebaseandframeworkandthereforeseemsoutsideofourcontrol.Lessapparentunderstand-ingofthenewenvironmentcancreateasenseofgreaterriskeveniftheobjectivelevelofriskinthesystemisunchangedorreduced.Thecaseforthisconjectureisexploredindirectlyinthesectionstofollowbydiscussingtheinstitutionalandknowledge-basechangesneededintheareasofriskmanagement,identificationofriskcategories,theaccountingsystem,andmethodsforimplementingbothregulatoryandstabilizationpublicpolicy.2SeeAllenandGale(1994),Finnerty(1992),Masonetal.(1995),Merton(1992a),Miller(1991),andSanford(1993).3SeeBemstein(1992)foracarefullyresearcheddescriptionofthisinteractionbetweentheoryandpracticeinbringingaboutsomeofthemajorinnovationsofthelastfewdecades.Merton(1994)providesabriefoverviewontheroleofmathematicalmodelsinfinancepractice.4Itisallthemoreperplexingbecausederivativesecuritieshavelongbeenintegralpartsofthefinancialsystem.AsdiscussedinMerton(1992a,13),options,forwardcontracts,andfutureshavebeenaroundsincethe17thand18thCenturiesinEurope,theUnitedStates,andJapan.Amongtheearliestderivativesecuritiesarebankcurrencies(money)whichderivedtheirvaluefromtheirconvertibilityintotheunderlyinggoldheldindepositories.R.C.Merton/JournalofBanking&Finance19(1995)461-4812.Financialinnovationandriskmanagement463Lookingatfinancialinnovations-fromtheperspectiveofphysiologyratherthanpathology-oneseesthemastheforcedrivingtheglobalfinancialsystemtowardsitsgoalofgreatereconomicefficiency.Inparticular,innovationsinvolv-ingderivativescanimproveefficiencybyexpandingopportunitiesforrisksharing,byloweringtransactioncostsandbyreducingasymmetricinformationandagencycosts.Someseetheextraordinarygrowthinderivativessecuritiesoverthepastfiveyearsasonlyafad.Indeed,aUSSenatorrecentlyreferredtoitasanelectronicPonzischeme.Howeveramorelikelyexplanationfortheenormousincrease