Design of financial systems

Robert C. Merton and Zvi Bodie have an interesting article that proposes a functional approach to designing and managing the financial systems of countries, regions, firms, households, and other entities, by a synthesis of the neoclassical, neo-institutional, and behavioral perspectives.

Their Functional and Structural Finance (FSF) theory seeks to combine the traditional neo-classical theories on frictionless markets, rational agents, and efficient outcomes with two additional attributes - an institutional approach (see here) that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and a behavioural approach (here, here, here, and here) that focuses on the ways in which and the conditions under which economic actors are not rational.

This approach recognizes the fact that neo-classical models cannot satsifactory predict or explain the institutional structure of financial systems, or how specific types of financial intermediaries, markets, and regulatory bodies will or should evolve in response to underlying changes in technology, politics, demographics, and cultural norms.

(HT: Baseline Scenario)