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Merton Discusses Risk Management at Dean's Seminar
If you're saving for your child's college education, you're probably putting money in growth funds, hoping that the returns a decade or more down the line will be enough to pay for tuition. But what if your returns fall short? It's a dilemma that's becoming all too familiar as individual households increasingly must make sophisticated financial decisions.
Last November, Robert C. Merton, the George Fisher Baker Professor of Business Administration at HBS, discussed this problem and elaborated on the importance of risk management in financial institutions at the first Dean's Research Seminar, a series established by Dean Kim B. Clark to increase awareness of HBS faculty research and to encourage cross-unit collaboration and discussion at the School. Roberto de Mendoza (MBA '74), vice chairman and director of J.P. Morgan & Co., Inc., served as the discussant.
As one of the authors of The Global Financial System: A Functional Perspective, which analyzes the world's financial institutions, Professor Merton addressed seminar participants - including HBS faculty, research associates, and students - on behalf of the School's Global Financial System Project. Merton is an expert in the areas of capital markets, financial services, and corporate finance.
"New financial product and market designs, improved computer and telecommunications technology, and advances in finance theory during the past quarter century have led to dramatic changes in the structure of global financial markets and institutions," noted Merton in his opening remarks. He then discussed the modern contracting technologies underlying popular new financial products that are being used in myriad ways to serve households and corporations.
Merton explained that deregulation and other legislative changes have led to the "disaggregation" of financial services. "For example," he said, "mutual funds rather than banks now provide many types of services." The cumulative effect on households is that individuals must now make major financial decisions involving risk, he observed, adding, "It is not clear that most people have the right training or support to make these decisions."
Merton maintained, however, that this trend will soon shift, leading to the creation of more user-friendly products for households. Using tuition as an example, he explained that in the future, households wanting to save money for education may be able to buy a "contract" with a financial institution that will lock in the cost of tuition at today's rates. By making payments to such a contract rather than investing in growth funds, they will be able to avoid the risks associated with changing market conditions or tuition increases - instead, the institution will bear the risk.
Corporations are also using contract technologies for strategic purposes. To illustrate, Merton cited a hypothetical example of a company with widespread crude-oil reserves and a major distribution system for heating oil and gas - but no refining facility. Instead of building or acquiring a facility, as it might have done in the past, the company could establish "swap-type" contracts with perhaps multiple parties, in which it would deliver crude oil and receive in return a mix of refined petroleum products. "Those contracts, in effect, would provide the company with the stability and predictability that go with refinery ownership," said Merton, "even though the company may not possess the actual physical technology."
Given that these kinds of contractual scenarios will involve financial institutions in substantial and new risk exposures, Merton noted that "risk management will become an essential internal process for the lending institution if it expects to remain viable and competitive." By demonstrating mathematically how to determine and hedge risk exposure for any new contract, Merton described for the audience the foundation for a possible future profession: risk accounting.
J.P. Morgan's Mendoza followed Merton's remarks with a brief discussion about specific structural changes currently taking place in the banking industry. Some institutions, he said, are consolidating around a single service (such as credit-card processing), while a few continue to offer diversified products and services. Many, he noted, are becoming global retail or wholesale businesses. "Time will tell which strategy will succeed," Mendoza concluded.
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