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Risk bearing, implicit financial services, and specialization in the financial industry

  • J. Christina Wang
  • Susanto Basu

What is the output of financial institutions? And how can we measure their nominal and, more importantly, real value, especially since many financial services are provided without explicit charges? This paper summarizes the theoretical result that, to correctly impute the nominal value of implicit financial service output, the “user cost of money” framework needs to be extended to take account of the systematic risk in financial instruments. This extension is easy to implement in principle: One can continue using the current imputation procedure, and the only change needed is to adjust the reference rates of interest for risk. ; The paper clarifies why the risk-related income is not part of the output—or equivalently, why risk bearing is not a service—of financial institutions. The paper next argues that, to measure real output, one must first explicitly specify and define the economic services produced by financial firms, a step that is absent from the “user cost of money” theory. Once it is established that only financial services, and not instruments, should be counted as the value added of financial firms, it follows that the quantity of services provided by these institutions is not necessarily in fixed proportion to the volume of instruments. The corollary is that the implicit price of financial services bears no definitive relationship with any reference rate. Instead, price deflators for financial services should be constructed using methods similar to those used for other services.

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Paper provided by Federal Reserve Bank of Boston in its series Public Policy Discussion Paper with number 06-3.

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Date of creation: 2005
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Handle: RePEc:fip:fedbpp:06-3
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  1. Lawrence J. Radecki, 1999. "Banks' payments-driven revenues," Economic Policy Review, Federal Reserve Bank of New York, issue Jul, pages 53-70.
  2. Allen N. Berger & David B. Humphrey, 1997. "Efficiency of Financial Institutions: International Survey and Directions for Future Research," Center for Financial Institutions Working Papers 97-05, Wharton School Center for Financial Institutions, University of Pennsylvania.
  3. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
  4. Barnett, William A & Kirova, Milka & Pasupathy, Meenakshi, 1995. "Estimating Policy-Invariant Deep Parameters in the Financial Sector When Risk and Growth Matter," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1402-29, November.
  5. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  6. Donal J. Donovan, 1978. "Modeling the Demand for Liquid Assets: An Application to Canada (Etablissement d'un modèle de demande d'actifs liquides: application au Canada) (Construcción de un modelo de demanda de activos líqu," IMF Staff Papers, Palgrave Macmillan, vol. 25(4), pages 676-704, December.
  7. Hancock, Diana, 1985. "The Financial Firm: Production with Monetary and Nonmonetary Goods," Journal of Political Economy, University of Chicago Press, vol. 93(5), pages 859-80, October.
  8. Barnett, William A., 1980. "Economic monetary aggregates an application of index number and aggregation theory," Journal of Econometrics, Elsevier, vol. 14(1), pages 11-48, September.
  9. Diewert, W E, 1974. "Intertemporal Consumer Theory and the Demand for Durables," Econometrica, Econometric Society, vol. 42(3), pages 497-516, May.
  10. Fama, Eugene F., 1984. "The information in the term structure," Journal of Financial Economics, Elsevier, vol. 13(4), pages 509-528, December.
  11. Dennis J Fixler & Marshall B Reinsdorf & Shaunda Villones, 2010. "Measuring the services of commercial banks in the NIPA," IFC Bulletins chapters, in: Bank for International Settlements (ed.), The IFC's contribution to the 57th ISI Session, Durban, August 2009, volume 33, pages 346-349 Bank for International Settlements.
  12. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
  13. Lawrence J. Radecki, 1999. "Banks' payments-driven revenues," Staff Reports 62, Federal Reserve Bank of New York.
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