Commentary Finance theory and The shift to integration From individual households to entire nations, the future of financial services lies with
Integrated products that are more comprehensive, simpler to understand and more
reliable for the user. The future of risk management rests in helping the producer handle
the greater complexity of creating and maintaining those products.
By Professor Robert Merton
isk is the central element that
influences financial behav­
iour. Measuring that influ­
ence, and analysing ways of
controlling and allocating risk. require so­
phisticated mathematical and computa­
;tional tools. Indeed. mathematical models
of modern finance practice contain some
of the most complex applications of prob­
ability and optimisation theory. Those ap­
plications challenge the most powerful
computational technologies.
There are twO essentially different fr.lmes of reference for trying to analyse and understand innovations in the finan­
d;i/ system. One perspective takes as
given the existing institutional structure of
financial service providers, whether they
be governmental or private sector. and ex­
amines what can be done to make those
institutiOns perform their particular finan­
cial service more effiCiently and profitably.
An alternative to this traditional insti­
tutional perspeaive - and the one [ favour
- is the funaional perspective. which takes
as given the economic functions served
by the financial system and examines what
is the best institutional structure to per­
form those functions. The basic funaions
of a financial system are essentially the
same in all economies, which makes them
far more stable, across time and across
geopolitical borders, than the identity and
struaure of the institutions performing
them. Thus, a funaional perspective of­
fers a more robust frame of reference than
an institutional one, especially in a rapid­
ly changing financial environment.
It is difficult to use institutions as the
conceptual "anchor" for forecasting finan­
cial trends when institutional structures are
themselves changing Significantly - as has
been the case for more than two decades,
and which appears likely to continue well
into the future.
During the past 25 years, finance the­
ory has been a good predictor of future
changes in finance practice. That is. when
theory seems to suggest that an institu­
tion, instrument or a service "should be
there" and it is not, praaice has evolved
R
so that it is. Placed in a normative con­
text. current theory has been a fruitful
source of ideas for subsequent innova­
tions in finance practice.
existing products such as mutual funds
being transported into technologically
less-developed financial systems. This
may be true, especially in the immediate
future, with the widespread groMh of rel­
Market completeness atively inexpensive Internet access. How­
The Black-Scholes option pricing theory ever, the creation of all these alternatives
is, of course, the most celebrated instance. combined with the deregulation that
However. it is surely not a singular case. made them possible has its consequences.
Elementary state-contingent securities, de­
Deep and Wide-ranging disaggrega­
veloped as a theoretical construa by Ken­
tion has left households with the respon­
neth Arrow in 1953 to explain the function sibility for making important and
ofsecurities in risk-bearing, were nowhere technically complex micro financial deci­
to be seen in the real world until the broad sions involving risk. such as detailed asset
development of the options and deri\'a­
allocation and estimates of the optimal
level of life-cycle saving for retirement.
ti\'e security markets.
As we all know. it is now routine tor
These are decisions they had not had to
financial engineers to use digital options make in the past, are not trained to make
and other Arrow-like derivative instru­
in the present and are unlikely to execute
ments in analysing and creating new fi­
efficiently in the future, even with at­
nancial products. More broadly. Arrmv's tempts at education.
notion of "market completeness". long
The availability of the Internet may
treated as a purely theoretical concept. is help to address some of the information­
now seen as a (nearly) achievable long­
asymmetry problems for households with
run goal for real-world financial markets. respea to commodity-like products for
Finance theory thus plays useful dual which the quality of perfornlance
roles: as a positive model for predicting promised is easily verified. However, the
the future direction of financial innova­
Internet does not solve the "principal
agent" problem with respect to more fun­
tion. changes in financial markets and in­
termediaries, and regulatory design. as damental financial advice dispensed by an
well as being a normative model for iden­
agent.
tifying new product and service opportu­
For this reason, I believe the future
nities. Although framed in the positive trend will shift towards more imegrJ.ted fi­
context of ·what will the trends be?", the nancial produas and serYices, which are
following remarks could apply equally in easier to understand, more tailored to­
the normative context of ·what should the wards individual profiles and permit much
trends be?".
more effeaive risk selection and control.
Lel's try to use finance theory, specif­
The integrated financial services in the
ically the functional perspective, to talk impending future, unlike the disaggregat­
about future trends in both financial prod­
ed financial services ofthe recent past, will
ucts and services: households, non-fi­
focus on the customer instead of the prod­
nancial firms and governments.
ua as the prime unit of a((ention. That is.
the service begins by helping the cllstomer
o Households: As a result of major tech­ design a finanCial plan to determine his
nological innovation and wide-spread optimal life-cycle needs and then finds the
deregulation, the household sector of products necessary to implement that in­
users in the more fully developed finan­
tegrated plan in a cost-efficient manner.
cial systems have experienced a major sec­
The past generation has seen explo­
ular trend of disaggregation - also called sive growth in asset management. Since
disintermediation - of financial services.
1974, US mutual fund assets alone have
Some see this trend continuing, with increased 125-fold from 548 billion to
48. RISK' JULY 1999
­
lutu
around 56 trillion, [n this time, the finan­
cial services industry has made great
strides in developing and improving port­
folio allocation and performance mea­
surement. However, the central objective
function employed, even in sophisticated
practice. is still the same basic mean-vari­
ance efficient-frontier criterion developed
by Markowitz, Tobin and Sharpe in the
19505 and 1960s, This criterion, based on
a static one-period model of maximising
the expected utility of end-of-period
wealth, is simply not rich enough to cap­
ture the myriad of risk dimensions in a
t ::nds:
sion models and performing an advisory
role. They should also expect to under­
take a principal intermediation role as ei­
ther issuer or guarantor to create financial
instruments that are simpler for house­
holds because they eliminate 'shortfall­
or "basis' risk.
Paradoxically, making the products
more user-friendly and simpler to under­
stand for customers will create consider­
ably more complexity for their producers.
The good news for the producers is this
greater complexity will also make reverse­
engineering and 'product knock-offs' by
service firms and a parallel need for more
sophisticated approaches to external
oversight
.
All of this will Significantly change the
role of the mutual fund. from a direct re­
tail customer product to an intermediate
or "building block' product embedded in
the more integrated products used to im­
plement the consumer's financial plan.
The fund of funds is an early. crude ex­
ample. In the future. the position and func­
tion of the fund will be much like that of
individual traded fums today. with port­
folio managers, like today's CEOs. selling
their stories of superior performance to
profeSSional fund analysts. who then make
recommendations to retail "assemblers".
As we know, commercial marketing is
very different from retail marketing, and
some fund institutions may have difficul­
ty making the transition. How and what
institutional forms will perform the retail
assembly and distribution functions is not
clear.
[t does seem, however. that a fully ver­
tically integr.ilted financial service firm
that limits its front-end assembly opera­
tion to using only its own funds and prod­
ucts will be at a distinct disadvantage,
because it will not have the breadth of
high-quality bUilding blocks with which
to assemble the best integrated products.
o Non-fmandal ftrms: Common prac­
real-world lifetime financial plan.
The household products and services
of the future will be much more compre­
hensive and integrative. They will marry
risk control and protection with optimal
saving plans for lifetime consumption­
smoothing and bequests. To arrive at the
necessary integrated lifetime consump­
tion and asset-allocation decisions, more
advanced financial models are required
than have been used in the past.
The underlying analysis will have to
combine the traditional efficient risk-re­
turn lr.lde-off for the tangible-wealth port­
folio, accounting for human-capital risks
and returns, hedging the risks of future
reinvestment rates and relative consump­
tion goods prices, incorporating mortali­
ty and other traditional insurance risks as
well as income and estate tax risks.
In the ne"''' environment of these inte­
grated retail products, success for finan­
cial services providers will require much
more than simply developing these deci­
second-movers more difficult and, there­
by, protect margins and create franchise
values for innovating firms, Hence, cre­
ativity in financial engineering, and the
technological and transactional bases to
implement that creativity. reliably and cost
effectively. are likely to become a central
competitive element in the industry.
A key element of the success of these
highly integrated, user-friendly products
in the household sector will be to find ef­
fective organisational structures for en­
suring product performance: that is, that
the contingent payments promised by the
products are actually paid by the issuing
institution. The need for assurances on
contract performance is likely to stimulate
further development of the financial guar­
antee business for financial institutions.
In general, the greater complexity in
products combined with the greater need
for contract performance will reqUire
more elaborate and highly quantitati\'e
risk management systems within financial
4' • RISK • JULY tH'
tice for the management of the corporate
pension fund is to treat it as if it were the
only asset of a firm that has pension
promises as its only liability. Improved
management of pension assets is to con­
sider them as an integrated part of the
firm's total assets. Indeed, taking into ac­
count risks on both sides of the balance
sheet is fundamental to proViding effec­
tive financial services to non-financial
firms in general. Enterprise risk manage­
ment is one term for such a unified ap­
proach. The movement from tactical to
strategic application of currency. interest
rate. conunodity and equities hedging is
already under way, Progress is being
made in combining market and tf'.ldi­
tional insurance risk management. quan­
tifying operational risk and integrating
market and credit risks.
Another important area for future de­
velopment is the management of factor
risks, particularly labour, Firms cao be
leveraged with their explicit and implicit
-
Commentary In thinking about the performance
issue and it~ implication for evaluating
policy. I was drawn to the technology of
a well-studied problem in risk and per­
formance measurement for investment
management and financial firms. This is
the problem of configuring all the de­
composition and reintegration of risk-fac­
tor exposures that must be determined
within a financial institution before the
aggregate risk measures, such as \'alue­
at-risk, can be applied. I believe that this
technology. if properly adapted. can be
:J Governments: A consequence of all used to measure country risk exposures.
In prJctice, measuring the differences
this prospective technological change will
in country exposure is not a simple task
be the need for greater analytical under­
as many asset classes are not traded at all.
standing of valuation and risk manage­
But, technically, this is the same problem
ment by users, producers and regulators
faced in the risk measurement of non­
of financial services. Furthermore. im­
traded assets and liabilities in financial in­
provements in these products and ser­
stitutions. In short, it is like the VAR and
vices will not be effectively realised
stress-testing challenges extended to in­
without concurrent changes in the finan­
clude non-traded asset~ and liabilities.
cial "infrastructure" - the institutional in­
However, as with the application to fi­
terfaces between intermediaries and
nancial institutions, I see this as a tough
financial markets, regulatory practices, or­
engineering problem, not one of new sci­
ganisation of trading, clearing, settlement,
ence - we know how to approach it in
other back-office facilities and manage­
principle and what we need to model. but
ment information systems.
the challenge lies in actually doing it.
To perform their function as both user
As with conventional applications.
and overseer of the financial system, gov­
country risk exposures give us important
ernments in the future will need to both
information about the dynamics of future
understand and make use of new finan­
changes that cannot be inferred from the
cial technOlogy. This new financial tech­
nology is critical to the provision of standard "country" accounting state­
ments. either the country balance sheet,
risk-accounting standards, designing
country income or flow-of-funds state­
monetary and fiscal policies, implement­
ments. That is, information not ex­
ing stabilisation programmes and finan­
tractable from even a mark-to-market
Cial-system regulation.
There is already a major effort under
accurate listing of the value of assets in­
,,'ay, almost worldwide, with respect to cluding foreign reserves, or from the
trade flows or capital flows.
restructuring the institutional roles played
.A.s we discover with more conven­
by government and the private sector in
tional applications of risk management
providing pensions benefits during re­
systems, once we can measure our risk
tirement.
exposures, it is difficult to resist explor­
ing whether we could improve things by
changing those exposures. Take Taiwan,
However, most intrigUing about the
prospective financial development sur­
for example. Suppose it decided to try to
align its risk exposures more with the
rounding government is the measurement
world ponfolio. In the past, that might
and management of country risk. While
lead to an industrial policy to develop an
in Asia last year, I was asked about the
automobile industry. Very inefficient.
Asian crisis. How do we explain different
However. as we know from modern
countries' relative performance and the
variations in performance across regions? contracting technology, it is now feasible
to separate decisions about risk exposure
And what do we do about it?
This stimulated a chain of thought. In
from decisions about investment. Instead
of physically' building a new industry, we
particular. it prompted another question:
How much of what we observe expost is
can imagine Taiwan implementing its risk
a consequence of ex ante different risk
policy by entering into swap contracts in
which it is a payer of the returns on a
profiles' After alL Taiwan is heavily into
world electronics portfolio and a receiv­
electronics but produces no automobiles.
More generally, few, if any countries. are er of the returns on a world automobile
portfolio.
well-diversified when measured against
the world market portfolio - the theoret­
Would such a swap be feasible' It is
ically best-diversified ponfolio if all as­
certainly structurally attractive. On the
sets, including human capital. were
ability to pay, Taiwan is a net payer when
traded or could be hedged and there were
electronics outperforms autos and a net
labour contracts in a parallel fashion to the
more tmditional financial leverage with
debt. Both temporJry-employee firms and
consulting firms serve the function of
"labour intermediaries". allowing more ef­
ficient management of the risks for both
those who supply bOOur and those who
demand it. Their rapid gro..... th. both in the
l:S and abroad. is probably a good mea­
sure of the significance of these factor risks
to enterprises. The point. again, is inte­
grated risk management for firms.
Country risk
forms. There is no moral hazard or major
asymmetric information problem for the
country's counterparties, because pay­
ments are not based on country-specific
performance in an industry.
For the same re<lson. it avoid~ the po­
liticaLeconomic issue that the country'S
government can be acc)Jsed of "gh'ing
away" its best assets, as sometimes hap­
pens when foreigners buy the shares of
it<; industries, bec-Juse the country gets to
keep its ·'alpha". Expropriation risk is also
minimised. both because there is no prin­
cipal exposure and because (returning to
the first structural point) the likely ability
to pay is aligned with the liability. Final­
ly. while the useful implementation of
such a swap obviously requires a large­
size market, there are natural counterpar­
ties: other countries seeking alignment.
These points seem to mitigate the
usual incentivelinformation asymmetry
problems for transactions with sover­
eigns. The technical problems involved
with building a set of surrogate portfolios
to use as benchmarks for risk measure­
ment and contract specification are un­
derstood. Initially at least, using mixtures
of trJded indexes as the underlying asset
for sv,"ap purposes would surely make the
liquidity much better and settlement ele­
ment<; easier. Contract credit risk is im­
portant, but here too we know a lot about
designing solutions, whether by a com­
bination of mark-to-market collateral.
purchase of private-sector performance
guarantees, or efforts involving gm'ern­
ment and quasi-gO\'emment institutional
guarantees.
While the benefits ofcountry-risk man­
agement systems and the associated mar­
kets would be expected to accrue to all.
those in smaller countries with develop­
ing financial systems have the greater po­
tential to benefit. With more concentrated
investment opportunities, they should
gain disproportionately from de\'eloping
global access for capital and, perhaps
more importantly. from more efficient al­
location of risk.
Moreover, if they design their financial
system using the most Up-to-date finan­
cial technology, these countries ca n -lea p­
frog" existing systems in terms of
efficienty. And in so doing, they can dra­
matically reduce the cost of investment
capital and thereby materially increase na­
tional wealth.
With the developed countries. Japan
in particular, and the emerging ones both
making major changes in their financial
systems at the same time, this may be an
especially opportune time to explore
country risk management. It is certainly
an opportune time to be a finance pro­
feSSional, engineer or architect. •
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