Financial intermediation and financial innovation in a characteristics framework

This paper shows that the characteristics model provides a unifying framework for analysing both financial intermediation and the process of financial innovation. The role of the financial intermediary is to buy-in the primary liabilities of the firm, unbundle and repackage the characteristics contained in them and issue a set of ultimate assets to households. Assets exist because the balance between the supply of and demand for asset characteristics indicates an interior equilibrium. Financial innovations arise whenever changes in supply and demand induce movements from a corner solution to the interior. A number of existing explanations of financial innovation can be expressed using this framework.