On the Application of Portfolio Theory to Depository Financial Intermediaries

Abstract

It has long been recognized that the useful application of the portfolio selection theory of Markowitz [10] and Tobin [19], [20] is limited by the restrictive assumptions placed on the utility function, distribution of returns, wealth holdings, and dynamic behaviour of the individual economic unit. Recent research by numerous individuals has indicated, however, that many of the implications of the Markowitz-Tobin theory can be derived from a weaker set of assumptions. The net result is a remarkably strong set of propositions and theorems with a wide variety of applications including intuitive insights into the gains from diversification, empirically useful algorithms for common stock selection, and theoretical advances for understanding the demand for money and the general equilibrium of financial markets. In this paper we discuss the application of these principles of portfolio selection to the behaviour of a depository financial intermediary. This notion is not, of course, entirely novel. For one thing, the extensions of the Markowitz-Tobin theory to include short sales (see Lintner [9]) and mutual fund behaviour (see Merton [12] and the cited studies) indicate that at a sufficiently high level of abstraction the available theory may be directly applicable to financial intermediaries. For another, empirical studies are now available that attempt to explain financial intermediary behaviour on the basis of the principles of portfolio theory (see Parkin [13]). In the case of the extended Markowitz-Tobin model, however, it is to be stressed that it may be applied to depository financial intermediaries only by abstracting from many of the institutional and market factors that make these intermediaries unique, and thus there does remain the need to develop a theory that explicitly incorporates these factors. With respect to the empirical studies, the primary objective has been the estimation of demand functions for financial assets, and thus there has been little attempt to derive the theoretical propositions that become available when portfolio theory is applied to financial intermediaries.