Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

How far can finance be simplified? Part I

In the wake of the global financial crisis, there has been a lot of
discussion about how finance became too complex and how it needs to be
simplified. This led me to speculate on how far finance can indeed be
simplified. This is a question that I would like to address in
several parts as I use this blog to clarify my own thoughts. Caveat:
my entire speculation is completely ahistorical – it is a clean
slate design which ignores the existing institutional structure
completely.

In this post, I describe an ultra-minimalist financial sector that
has a payment system, a spot foreign exchange market,
“pure” life insurance companies, an equity market and
practically nothing else. In this ultra-minimalist model, there are no
banks, no central banks, no debt markets and no derivative
markets. The payment system would essentially be a retail version of a
real time gross settlement system which in principle needs neither
banks nor a central bank. It is essentially a piece of technological
infrastructure and nothing more – a central depository for
cash. Money could be fiat money or commodity money or anything
else.

By pure life insurance, I mean first of all that the companies
offer term insurance which unlike endowment insurance is not bundled
with investment products. Secondly, level premiums would be replaced
by rising (actuarially fair) premiums so that there is very little
investment component in the insurance product. Finally, insurance
would ideally be redesigned so that the life insurers take micro
mortality risk (the cross sectional variation in mortality rates at a
point in time) but not macro mortality risk (changes in life
expectancy over time).

If we can make these changes, insurance companies become easy to
run and easy to regulate. They simply become applications of the law
of large numbers and involve vastly reduced risk taking over long
horizons. Incidentally, I believe that macro-mortality risk is
practically unhedgeable and uninsurable. Insurers can credibly claim
to provide protection against this risk only by having recourse to a
bail out by the state. Perhaps, it is ultimately beyond even the
resources of the state to credibly insure against macro-mortality
risk.

In the absence of debt, there are hardly any prudential regulations
except possibly for the insurance companies. Financial regulation
consists primarily of conduct of business regulators and consumer
protection regulators.

How can a financial system operate without debt? Well, the
Modigliani-Miller theorem says that lack of debt is not a serious
problem for the corporate sector except that the tax advantage of debt
is lost. One could assume that the government simply enacts a lower
rate of corporate tax so that the elimination of tax deductible
interest is revenue neutral to the state.

If there is no leverage of any kind, the need for derivative
markets is vastly reduced. Corporate use of derivatives is principally
to economize on equity capital. Since equity is the ultimate hedge of
every conceivable (and inconceivable) kind of risk, if you have enough
of equity, you can choose not to hedge anything at all and still you
will not go broke. One could use a version of the Modigliani-Miller
argument to show that corporate hedging is irrelevant unless it
introduces deadweight losses like bankruptcy costs.

This is not the whole story because apart from corporate hedging we
must also worry about optimal allocation of risk among individuals. I
believe however that in the spirit of Arrow’s 1964 paper
(“The role of securities in the optimal allocation of
risk-bearing”), the equity markets span sufficient states of the
world to permit a reasonable allocation of risk bearing among
individuals. The practical consequences of not having a derivative
market may not be much in a world without debt.

General insurance is essentially a substitute for derivatives and
it too can be eliminated in this minimalist design. If corporations do
not have debt and if individuals hold diversified portfolios of non
human assets, then they can self-insure all forms of property
risk. Insurance is required only for non diversifiable human capital
which is why pure life insurance cannot be eliminated.

The Capital Asset Pricing Model would not hold because there is no
risk free asset. I do not see this as a problem because we would still
have the zero beta model of Black (1972) which is not significantly
more difficult to use. (As an aside, if we focus on real returns
instead of nominal returns, there is no risk free asset
anyway. Inflation indexed bonds issued by the government are subject
to significant default risk since the printing press is not sufficient
to pay off these bonds.)

Passively managed mutual funds (exchange traded index funds for
example) are nice to have because they allow individuals to achieve
diversified portfolios very easily. But if the stock exchange allows
shares to be traded in small lots, even small investors may be able to
hold 25-40 stocks directly and obtain most of the gains of
diversification. Exchanges could also allow basket trades in indices
to achieve the same thing.

In the ultra-minimalist design there is no trade finance other than
whatever trade credit one corporation chooses to extend to another out
of its own resources. There are no letters of credit (which are
actually highly complex credit derivatives!).

The absence of a debt market means that there are no mortgages. One
possibility is that most houses are owned by corporations that rent it
out to individuals. We do not need to own the homes that we live in
any more than we need to own the offices that we work in. (See my post
on this a year go.)Individuals would be able to obtain exposure to
real estate by buying shares of these companies. (Another – less
preferred – option is that people would live in rented houses in
early stages of the life cycle and buy houses only later in life.)

One difficulty with the minimalist design is the lack of
educational loans. Education would have to be financed through equity
claims to an even bigger extent than it is today. Even today, the
successful university that attracts lots of endowments essentially has
an equity claim (an out of the money call option?) on the human
capital of each of its alumni and the returns on this equity claim are
used to subsidize (finance) a lot of the education.

I see two big problems with this ultra-minimalist design. First is
that Jensen-Meckling pointed out in 1976 that the disciplining power
of debt is useful in reducing the agency problems between the managers
and the shareholders. We would therefore need very robust corporate
governance frameworks (including a healthy market for corporate
control) in a world without any debt. This would be a problem more for
mature businesses that generate a lot of free cash flow.

Second is that under the assumption that governments are and will
always be profligate, we need a government bond market. Theoretically
also government debt can achieve some intergenerational transfers that
would otherwise be difficult to accomplish, but I think this is less
important than the practical reality of governmental profligacy.

In subsequent blog posts, I hope to extend the ultra-minimalist
financial sector to allow for a corporate and government debt market
increasing complexity one step at a time.

On the whole however, even the ultra-minimalist financial sector
would be able to support a vibrant and modern economy. Clearly, it is
the equity market that does the heavy lifting in this minimalist
design by taking charge of both resource allocation and risk
allocation.

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2 responses to “How far can finance be simplified? Part I

  1. PH Test November 16, 2010 at 10:24 pm

    Life insurance is necessary that is why i always make sure that i get a reputable insurance company ;’:

  2. best hoover steam vac February 12, 2011 at 6:48 am

    Thanks for ones marvelous posting! I truly enjoyed reading it, you’re a great author.I will be sure to bookmark your blog and will often come back very soon. I want to encourage that you continue your great work, have a nice weekend!

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