Modern Financial Systems: Theory and Applications

CHAPTER 4

Financial System Organization and Change

Understanding the alignment of attributes with capabilities is key to understanding financial system organization. Some deals can profitably be governed as market transactions, while others require the capabilities provided by nonmarket governance. Most nonmarket governance is provided by intermediaries, but for some deals internal governance is the most cost-effective way of ensuring the expectation of a satisfactory conclusion. In sum, the three governance methods jointly complement each other, and the alignments they mutually reach endogenously determine financial system organization.

While there is a fixed and unchanging set of available governance capabilities, as well as a fixed and unchanging set of deal attributes, the capability mix utilized by a given governance mechanism can evolve over time, as can the attribute mixes of typical deals. Understanding the evolution of both is crucial to analyzing how deal governance can evolve over time, and equally crucial to understanding how financial systems themselves evolve.

This chapter examines financial system change. Change is driven principally by economics; financiers search for improved profitability, and clients search for lower-cost deals. Financiers seek to generate additional revenues by offering new products or entering new markets; they seek to decrease costs by achieving efficiency improvements in operations, in governance, or both. Changes in customary governance ...