The Economic Organisation of a Financial System

Edwin Neave

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351334303
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

Originally published in 1991, The Economic Organisation of a Financial System develops a descriptive theory of a financial system's organisation and functions and applies the theory of organisational economics to the study of a financial system. The book attempts to reconcile neoclassical financial theory and managerial finance by synthesising the main findings of these studies within an institutional economics framework. The book helps to relate the complementary perspectives of current theory and current practice and aims to strengthen the relations between both theory and practice. The book's contents provide a detailed illustration of how organisational economics can be put to work.

Chapter one

Introduction

The questions of how a financial system is organised and of why financial systems assume certain configurations are important topics for economic analysis, but they are questions which have not yet been examined extensively. Rather, financial theorists have focused on explaining various specialised aspects of financial system functions, and empiricists have applied their skills to testing such specialised explanations. Thus modern financial theory and the empirical studies based on it consider some financial system components in great detail, but leave others almost wholly unexamined. For example, many relations between securities prices are explained by arbitrage pricing theory, and a considerable number of such explanations are supported by data. On the other hand, speculative bubbles in securities prices, or enthusiasms for expanding certain lines of business at certain times, are much more controversial phenomena, and are currently much less satisfactorily explained. Yet these phenomena are also prominent features of modern financial systems.

Similarly, modern financial theory addresses only some of the relations between a financial system's specialised components, while leaving others quite unexplained. As already mentioned, modern financial theory emphasises price relations based on arbitrage, and many tests of arbitrage-based theories have been carried out. But neither theorist nor empiricist has yet devoted a corresponding degree of attention to, say, the linking functions performed by financial intermediation.

The methodology employed by modern financial theory helps to explain why its results have developed in the current specialised fashion. Nearly all modern financial theory uses the methods of neoclassical microeconomics, the approach of which assumes that each economic agent has a well-defined goal, such as maximisation of current wealth. These single-minded agents are faced with highly structured decision problems, within the framework of which they can readily select actions (optimal actions) best suited to achieving their purposes. The body of financial theory based on these assumptions of highly rational, highly structured decision making is work referred to henceforth as neoclassical financial theory.¹

The explanations of neoclassical financial theory are valuable in developing descriptive theory, not only because many theoretical propositions are highly satisfying from an intellectual point of view, but also because many of the theories’ predictions are supported by careful examination of financial market data. Work on the functions of public securities markets is a case in point. For, this work explains how market prices of securities are determined at equilibrium, and data from highly active public securities markets supports many of its principal predictions. As an additional advantage, this theory both complements and is complemented by microeconomics: it helps to define the circumstances in which markets can best perform the task of allocating financial resources.

As a second example of how neoclassical finance can contribute to developing a descriptive theory, other works explain some of the functions of financial intermediaries, and empirical studies provide information about intermediaries’ operating costs. When fitted into an appropriate synthetic framework, these results can be employed to help explain why a financial system is typically composed of both specialised financial markets and financial intermediaries, and to show how these different system components relate to each other.

On the other hand, the very strengths of neoclassical financial theory lie in assumptions which restrict the applicability of its explanations. In particular, decisions to enter new lines of business are not well explained by neoclassical financial theory, which offers little more than the view that innovation will be stimulated by perceptions of new profit opportunities. Neoclassical financial theory has little to say about how potential profit opportunities might be detected, nor about how strategies to exploit them might be formulated. Thus, other bodies of thought are needed to help organise and elaborate a more comprehensive view of financial system activity. For example, theories of decision making under uncertainty can be examined in a search for some explanations of how agents might take tentative, exploratory actions.

If agents’ characteristics and capabilities are to be viewed more broadly than they are within the confines of neoclassical financial theory, an integrating framework is needed to relate the neoclassical findings to other theories and to current practice. Although it has not previously been applied in extensive detail to the study of entire financial systems, institutional economics, with its focus on descriptive economic theories of actual institutions, can provide such a framework.² In particular, Oliver Williamson (e.g., 1972, 1988) argues that different, specialised kinds of financing arrangements are deliberately aligned with the requirements of different kinds of financial transactions in ways which render financial transacting as cost-effective as possible. Since it uses a broader interpretation of cost-effectiveness than does neoclassical financial theory, Williamson's approach provides a framework capable of synthesising the findings of the present study.

Since it examines relations between financial systems and economic growth, development economics can further supplement institutional economics’ explanations of financial system evolution. For, development economics addresses questions regarding the real and financial impacts of monetary, fiscal and regulatory policies, all of which can help supplement an understanding of financial system function and change. Incidentally, the converse may also be true: the analyses of this book may eventually contribute to the field of development economics. For, the latter has not yet extensively considered the importance of financial system composition: i.e., the influence of specific institutional arrangements on relations between economic and financial development.

The foregoing overview suggests that combining findings from the different fields just mentioned could be a worthwhile endeavour, and the rest of this Chapter outlines such an approach in greater detail. The next section provides a more detailed overview of neoclassical financial theory, and its successor indicates how these findings can be related within the institutional economics framework. The last section sketches the rest of this book's development.

Existing approaches

Considering a financial system in its entirety shows both where existing studies contribute to explaining system organisation and where additional work remains to be done. Neoclassical financial theory offers valuable explanations of how securities prices are determined, and empirical studies of highly active public securities markets confirm many of its propositions. Neoclassical theory has also made considerable progress in establishing the allocative and efficiency properties of financial markets. However, the results from neoclassical theory are derived under special assumptions which are simultaneously valuable and limiting. The value of the usual neoclassical assumptions lies in their potential for clarifying difficult analytical issues. As for limitations, the same assumptions rule out important practical considerations which also influence financial system form and functions.

Neoclassical financial theory largely depends on the assumptions of no (or inconsequential) transactions costs and well specified informational conditions. Theoretical investigations almost always assume either that agents use the same probability distributions or, if their views differ, that the differences can still be described as differences between well-defined probability distributions. Theoretical investigations rarely examine how such probability distributions are determined, nor do they consider what might occur if agents were not able to formulate the distributions at reasonable costs. In essence, neoclassical financial theory assumes that agents can formulate complex decision problems precisely and costlessly, and that they can determine the problems’ solutions accurately and costlessly. In the rest of this book, such agents will sometimes be referred to as hyperrational.

When agents are hyperrational, they understand clearly the relations between alternative decisions and the decisions’ impact on their respective wealth positions.³ Thus, the assumption of hyperrationality makes it easier to predict how agents will behave, and in some instances the predictions will be descriptively accurate. On the other hand, the assumption of hyperrationality excludes many interesting situations pertinent to a complete explanation of how financial systems are organised in practice, and how the agents in them actually operate. For these reasons, it is important to assess the scope of neoclassical financial theory's descriptive validity, and to consider what alternative, complementary explanations might be applicable when the neoclassical approach has a lesser degree of descriptive validity.

In practice, agents do not always have the computational capabilities possessed by their hyperrational counterparts. Moreover, the information on which real life agents base their actions is not always as well structured as neoclassical theory assumes. Rather, formulating decision problems and finding their solutions can prove to be costly tasks which agents are less than wholly competent to carry out. That is, nearly all neoclassical theory studies financial decisions in the highly structured settings which Knight (1933) referred to as risk, but many practical problems arise under conditions better characterised as Knightian uncertainty. These possibilities are only infrequently recognised: few recent financial theorists other than Williamson (e.g., 1988) examine circumstances which effectively retain Knight's (1933) classic distinction.

The importance of Knight's distinction rests on its ability to explain what would otherwise be puzzling phenomena. In the arguments to follow, many features of financial transactions will be explained in terms of their usefulness in dealing with uncertainty. Indeed, many existing financial practices cannot fully be explained unless the effects of uncertainty are recognised explicitly. To give a straightforward example, neoclassical financial theory cannot explain why practitioners use such rules of thumb as payback criteria, since examples can be constructed in which payback rules clearly conflict with the prescriptions of present value maximisation. Yet the problem with such demonstrations may be the manner in which the decision problem is posed: payback rules can also be interpreted as attempts to recognise and to deal with the effects of uncertainty.⁴

Neoclassical financial theory is similarly limited in its ability to explain financial system change. Indeed, it may fairly be said that the theory is better at explaining well established practices rather than it is at illuminating the creative or exploratory aspects of finance, the dynamics of technological change, or the evolution of sophisticated financial systems from primitive ones. For, financial system change largely occurs under uncertainty rather than under objectively specified risk, and many of the interesting features of uncertainty are assumed away when decision problems are formulated in a manner conducive to neoclassical investigation.⁵

Present approach

In its attempt to provide a descriptive theory capable of bridging some of the gaps between existing normative concepts and current practice, this book uses institutional economics to explain financial system organisation and change. Following Williamson (1988) the book first defines three basic governance mechanisms which can be used to effect and administer financial transactions – markets, financial intermediaries, and internal allocation procedures. Next, this book analyses the relative advantages of using each mechanism. These advantages differ according to the capabilities of the mechanisms, and according to how the capabilities relate to transaction requirements.

Each mechanism can be used to administer particular and distinct classes of transactions cost-effectively, but no one mechanism has an absolute advantage in administering all types of financial transactions. Differences between capabilities, along with differences in transaction requirements, mean that each governance mechanism has a cost advantage for administering at least some types of transactions. If this were not the case, the different types of mechanisms could not all continue to survive in a competitive financial system.⁶

This book also contends that the contractual terms of a financial transaction are chosen to meet transaction requirements cost-effectively. Accordingly, each transaction's governance structure – the combination of governance mechanism and contractual terms used to administer it – is chosen for its capabilities in dealing with the transaction's particular requirements.

The most effective way of carrying out a transaction depends on both the transacting agents and the transaction itself, particularly its informational environment. Thus the subsequent analysis specifies agents’ purposes, their capabilities, and the risks or uncertainties they perceive. In addition, some aspects of choosing a governance structure depend on interactions between the kinds of agents and the kinds of transactions with which they are concerned. For example, agents’ levels of competence, and changes in those levels, can determine whether transactions are better regarded as uncertain or merely risky. Thus agents with greater competence sometimes perceive transactions as merely risk, while their less competent fellows will behave as if facing uncertainty.

Agents’ attempts to transact cost-effectively explain financial system change as well as its static structure. Thus when transaction economics are changing, studying the changes’ effects can show how financial systems will typically evolve. Such explanations have more than descriptive usefulness: they can also be used to help choose appropriate policies, either for financial regulation or for enhancing financial and economic development.

To summarise, this book develops a positive theory of the economic determinants of financial system organisation and change. Its theme is to show how transactions’ requirements are aligned with governance capabilities to determine financial system form. Its development is based on a combination of neoclassical financial theory, institutional economics (largely as elaborated by Oliver Williamson), and observations of current practice. Principal findings of development economics are used to help round out the picture.

Outline of remaining chapters

The book is organised as follows. Chapter 2 defines the dimensions along which financial system activities are analysed. These dimensions include the nature of agents, their goals and the conditions under which they transact. While agents’ goals determine the system's basic driving forces, the nature of any informational differences between them, and the costs of dealing with these differences, profoundly affect the ways agents transact.

For example, transactions are much more simply effected when financier and client both view a transaction as merely risky, and particularly if they both assess the risks ...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• Figures
• Preface
• Chapter one Introduction
• Chapter two Financial system agents and environment
• Chapter three Governance mechanisms: major types
• Chapter four Specialised governance mechanisms
• Chapter five Aligning mechanisms with transactions
• Chapter six Managing transaction terms
• Chapter seven Managing portfolios
• Chapter eight System organisation and performance
• Chapter nine Financial system change and performance
• Chapter ten Finance and economic development
• Chapter eleven Conclusions
• References
• Index