A Model of Contract Guarantees for Credit-Sensitive, Opaque Financial Intermediaries'

As discussed in Merton (1993, Sections 5 and 6) and here in the section to follow, the effective delivery of many financial services depends critically on the credit-worthiness of the provider financial institution. Such service activities are said to be 'credit-sensitive'. The intermediary's credit standing can cause significant extemality-like effects on the various business activities of the intermediary, even when there are no interconnections among them. For example, the announcement by a U.S. investment bank that it is even thinking of entering into a new merchant-banking activity of extending bridge financing and other interim risk-taking positioning for restructuring firms can materially and negatively affect its over-the-counter derivatives-products business for corporate customers because those customers may perceive the risk of the merchant-banking involvement as jeopardizing the bank's ability to fulfill its obligations on its long-dated contractual agreements. Thus the potential merchant-banking business affects the derivative-products business although there is no overlap of personnel, customer base, location, or employee skill sets between them. The shared credit standing of the institution's individual businesses can therefore cause a significant failure ofthe principle of 'value-additivity', which complicates decentralization of the capital budgeting and financial decisions. The issue of monitoring credit quality are made more complex because those intermediaries such as banks and insurance companies that are principals to customer contractual agreements tend to be 'opaque' institutions, as defined in Ross (1989) and Merton