WHAT SHOULD BANKS REALLY DO?: COMMENT

In the July 1992 Contemporary Policy Issues edition, Lawrence J. White (1992) argues that the inherently unstable character of the banking system requires that depositors be protected by various types of government intervention. The comment here outlines the opposite argument: government intervention destabilizes an inherently stable banking system. A framework developed in the comment provides the basis for criticizing White's general approach and policy proposals .     

Default Risk in Futures Markets: The Customer-Broker Relationship

The traditional view of the futures clearinghouse as an insurer that eliminates the need for customers to evaluate default risk is inaccurate. A clearinghouse member default in 1985 confirms that the clearinghouse only guarantees payment from member to member, not from customer to customer or member to customer. Thus, non-defaulting customers are subject to losses as a result of the action of individuals with whom thay have no contractual obligations. This study models the behavior of customers choosing a futures commission merchant (FCM) given the current legal position of the clearinghouse. In a single-period model with symmetric information, customers can eliminate their exposure to defaults of other customers or of their FCM only by choosing to trade through “boutique” (undiversified) FCMs. In practice, monitoring and rebalancing costs may impede the attainment of zero default risk. However, FCM diversification remains an important factor in customer choice of an FCM. When setting capital requirements, clearinghouses and government regulators need to consider the implications of diversification for both customer and market protection.     

The Price of Immediacy

This paper models transaction costs as the rents that a monopolistic market maker extracts from impatient investors who trade via limit orders. We show that limit orders are American options. The limit prices inducing immediate execution of the order are functionally equivalent to bid and ask prices and can be solved for various transaction sizes to characterize the market maker's entire supply curve. We find considerable empirical support for the model's predictions in the cross-section of NYSE firms. The model produces unbiased, out-of-sample forecasts of abnormal returns for firms added to the S&P 500 index.