Customers and investors: A framework for financial institutions

Robert Merton, Richard Thakor

01 August 2015



Many types of financial intermediaries provide ‘credit-sensitive’ financial services – the efficient and effective delivery of these services depends on the credit-worthiness of the provider (e.g. Wigglesworth 2015).

This potential sensitivity of the perceived value of the intermediary’s services to the intermediary’s credit risk has important implications. We show this in a new study (Merton and Thakor 2015) in which we examine how this affects the contracts between intermediaries and their customers, and illuminates commonly observed features in real-world institutions and regulatory practices.

The roles of customers and investors in financial intermediaries

An important feature of financial institutions is that they receive financing from both investors and customers. Investors, such as stockholders or bondholders, provide risky financing – they expect the payoffs of their claims to be linked to the intermediary’s outcomes. Thus, investors provide risk-bearing as well as financing. 

On the other hand, customers who pay in advance for future payments and services provide financing, but who prefer not to have the payments and services received, depend on the fortunes of the service provider. Here, we focus on these ‘credit-sensitive’ customers.  These customers derive utility from the intermediary’s services, and this utility is diminished by an increase in the intermediary’s credit risk.

The key here is not the identity of the economic agent, but the role played by that agent, i.e. whether the agent is an investor or a customer who also provides the financing. Customers can be large and sophisticated institutions as well as unsophisticated retail individuals. In some instances, the agent may play multiple roles, and may therefore have different expectations of the institution in different roles.

This distinction between customers and investors leads to numerous observations regarding how financial intermediaries structure efficient contracts with their customers.  We argue that the efficient contract will need to ensure that the credit risk of the intermediary is borne by the right party, and that this is the investor, not the customer. Thus, the customer is optimally exposed only to the risk inherent in the contract terms — the risk that the contract itself has specified—and not to the credit risk of the intermediary itself.1

The economic intuition behind this result is that the intermediary is providing the customer a vector of services that creates a positive economic surplus, and the loss of this surplus due to the failure of the intermediary would represent a net social loss.  The efficient contract will be designed to minimise this loss. In other words, the contract will be inefficient if the payoff depends on a single institution’s risk — the customer is forced in this case to bear a non-systematic idiosyncratic risk, which is inefficient. The customer is unable to diversify away the intermediary’s idiosyncratic credit risk due to both transaction costs related to purchasing a number of smaller customer contracts from different intermediaries, and market incompleteness in contracting on the monetary and service portions of customer contracts. At a basic level, exposing the customer to this credit risk is akin to affixing a lottery to the customer’s contract which adds unnecessary risk-bearing with no added gain. In contrast to risk-sharing, this added uncertainty lacks social value, as the customer’s uncertainty is not accompanied by reduced uncertainty for any other agent. Investors, by comparison, are in the business of bearing this risk.

Examples of customer contracts

A variety of observed real-world customer contracts fit within our framework.

A bank depositor is an example of a customer who wants a sure payoff that is not exposed to the credit risk of the bank – those who guarantee these deposits in some way (e.g. implicitly, the shareholders and the subordinated debtholders and, explicitly, the deposit insurer) are investors who bear the risks that depositors do not. Another example is a customer who purchases an annuity from an intermediary – the customer is guaranteed certain income, independent of the fortunes of the intermediary even though the value of the annuity is stochastic. By contrast, a bond sold by the same institution represents a claim held by investors who are exposed to the idiosyncratic risk of the institution. Yet another example is someone who purchases life insurance. The policyholder does not wish to bear any risk of benefactors not receiving the promised payoff in the state of the world in which the insurance needs to pay off. Shareholders and those who purchase bonds in the insurance company are the investors and they are exposed to the risk in the overall payoffs of the insurance company. 

Regulatory practices and financial crises

One regulatory practice illuminated by our framework is government-guaranteed deposit insurance, which serves as a way to insulate depositors from the credit risk of the bank. In our framework, deposit insurance enhances the economic efficiency of the deposit contract by removing the customer’s exposure to the idiosyncratic credit risk of the intermediary.

Another regulatory practice is the protection of the largest banks in an economy by considering them to be too big to fail.  To understand this, we argue that bigger banks are more complex than smaller banks due to the greater intertwining of customers and investors in bigger banks. The bigger the bank, the more difficult it becomes to cleanly separate investors from customers.2 This intertwining means that there is no easy way to protect customers while exposing investors to credit risk, necessitating guarantees against failure to investors in order to protect customers. This provides a novel economic rationale for too big to fail.

A regulatory policy also designed to shore up banks in distress is to have ‘bail-in deposits’ – in other words, to transform deposits into equity when the bank is in trouble. Such a policy was implemented in the Cyprus crisis (see Zenios 2014 for a discussion). Our framework implies that this policy is inefficient because it forces customers to become investors.

Finally, our analysis also allows us to better understand financial crises, and how they are propagated.  A crisis can be thought of as an event that is outside of agents’ ‘model of the world’ – when the event happens, agents have difficulty reconciling it with their view of the world, and therefore lack a predetermined course of action. This defining element of a crisis is closely linked to the defining element of customers that we have described. Customers expect to receive a credit-risk-insensitive vector of services from contracts with intermediaries, so if they unexpectedly learn that these contracts are exposed to the impending insolvencies of these intermediaries, it can generate the same forces that give rise to a financial crisis – an unanticipated event which the customer assigned zero probability to, and thus does not know how to respond. Consequently, customers may withdraw their funds and cause a crisis. One of the reasons (even uninsured) intermediaries are so often bailed out by the government is because investors and customers are intertwined in complex ways in many crises, and the unpredictability of customer reactions represents another reason why regulators are unwilling to ‘roll the dice’ and let institutions fail.3

A perspective on informational transparency vs. opacity

Our approach also provides a perspective on whether banks should optimally be transparent or opaque. For example, Dang, Gorton, and Holmstrom (2013) and Dang, Gorton, Holmstrom, and Ordonez (2014) argue that banks should optimally be opaque in order to preserve risk-sharing for depositors (also see Holmstrom 2015 for a review), i.e. they should withhold information about the bank’s risk from depositors. 

In contrast, our approach suggests that in well-functioning markets, customers (like depositors) do not have a need for their contracts to be opaque, since their contracts should be optimally structured to insulate them from the risks of the service-providing intermediaries. Opaqueness may be beneficial to producers (e.g. banks), but our analysis suggests that it need not be beneficial to customers. Put differently, customers will be indifferent to opaqueness as long as their claims do not depend on the fortunes of the intermediary. Therefore, in high-quality debt markets, it does not need to be the case that transparency causes dysfunction or that opaqueness is necessary.

We have emphasised the distinction between ‘customers’ and ‘investors’ as a framing of the roles played by different groups of agents in funding financial intermediaries. Customers provide significant funding, but want no risk-bearing. In contrast, investors provide both funding and risk-bearing. This distinction leads to a rich set of implications, the most important of which is the economic rationale for designing efficient contracts that insulate customers from the credit risk of the intermediary and impose all of this idiosyncratic risk on the investors. This perspective helps to explain the design of a variety of contracts in the real world, as well as regulatory approaches to financial institutions.


Dang, T V, G Gorton, and B Holmström (2013), "The Information Sensitivity of a Security", unpublished working paper, Yale.

Dang, T V, G Gorton, B Holmström, and G Ordonez (2014), “Banks as secret keepers”, NBER Working Paper No. 20255.

Holmstrom, B (2015), “Understanding the Role of Debt in the Financial System”, BIS Working Papers No. 479, Bank for International Settlements.

Merton, R C (1989), "On the Application of the Continuous-time Theory of Finance to Financial Intermediation and Insurance", Geneva Papers on Risk and Insurance: 225-261.

Merton, R C (1993), “Operation and Regulation in Financial Intermediation: A Functional Perspective”, in P Englund (ed.) Operation and Regulation of Financial Markets, Stockholm: The Economic Council, 17-67.

Merton, R C (1997), "A Model of Contract Guarantees for Credit-Sensitive, Opaque Financial Intermediaries", European Finance Review 1(1): 1-13.

Merton, R C, and R T Thakor (2015), “Customers and Investors: A Framework for Understanding Financial Institutions”,  NBER Working Paper No. 21258..

Wigglesworth, Robin (2015), “S&P warns on DuPont’s creditworthiness”, Financial Times

Zenios, S A (2014) "Fairness and reflexivity in the Cyprus bail-in".


1 In other words, a customer may understand that the contract he/she purchases from an intermediary may have a risky payoff (for example, a mutual fund account that is indexed to the S&P 500). However, the customer does not want any uncertainty about receiving the promised payoff because the intermediary is insolvent.

2 We want to emphasise that what is at issue here is not just the sheer size of the bank’s balance sheet, but rather its complexity that leads to intertwining of credit-sensitive customers and investors and thereby the systemic nature of the risk involved in large bank failures.

3 Indeed, when such institutions go through bankruptcy, customers are inexorably caught up in the bankruptcy process, which makes it uncertain what claim they will eventually get through the courts.




Topics:  Financial regulation and banking

Tags:  financial services

School of Management Distinguished Professor of Finance, MIT Sloan School of Management

PhD Candidate in Financial Economics, MIT Sloan School of Management