Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Simplified Finance: Part II

In my earlier post (see Part
I
) on this subject, I talked about an ultra-simplified financial
system that “has a payment system, a spot foreign exchange
market, “pure” life insurance companies, an equity market
and practically nothing else … no banks, no central banks, no debt
markets and no derivative markets.”

I did emphasize that my speculation was completely ahistorical. I
did not perhaps make it clear that I also assumed fairly well
developed legal systems and governance structures without which equity
markets are a complete non starter. In early stages of economic and
financial development, it is difficult to create equity markets that
work. I have no quarrels with the claim (for example at the Lin
roundtable
) that stock exchanges are pre-mature at that stage of
development.

Coming back to the minimalist design, the next thing that one would
want to add would be a debt market. First a government bond market and
second a corporate bond market.

I mentioned in my first post that the government bond market is as
above all a concession to the practical reality of governmental
profligacy. Many people that I talk to think of government bond
markets as mechanisms that increase the asset allocation opportunities
for investors and allow them to choose less risky portfolios if they
like. I think that a lot of this is money illusion. Government bonds
are in fact very risky because of the ever present threat of inflation
and hyper inflation. The tail risk of bonds is greater than the tail
risk of equities.

The introduction of government bonds does not by itself require the
introduction of any other markets including interest rate
derivatives. These derivatives are needed when you have leveraged
financial institutions and in the minimalist design so far there are
no such institutions.

Adding a corporate bond market is more complicated because it
creates leveraged entities. It is difficult for leveraged entities to
exist without derivative markets particularly commodity and currency
derivatives. We could avoid this by having only long term corporate
bond markets. The absence of financial institutions and short term
debt markets would automatically limit the leverage of firms and then
it may be possible to get by without derivative markets.

More troublesome is that adding corporate bonds without adding
banks and other financial intermediaries would create a strong bias
against small firms. It is easier for small firms to access equity
markets than it is for them to access corporate bond markets. To level
the playing field, it may be necessary to add bank like intermediaries
that would lend to smaller enterprises. But once we add leveraged
financial intermediaries, it is impossible to have a simplified
financial system anymore as I shall discuss in the next part of this
series.

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One response to “Simplified Finance: Part II

  1. Ritwik July 17, 2009 at 10:28 pm

    Sir,

    If I understand you correctly, then the only reason why commodity and currency futures markets are being avoided is because the financing is either completely equity or purely long term debt, thus encouraging a rail road company or a steel company to take the risk that it would normally avoid with short term debt. (Using the classic justification of the necessity of a steel futures market) In this case, isn’t the principal agent problem not being ameliorated to the correct extent? Second, credit (and correspondingly, the fractional reserve banking system) exists to provide liquidity to bright business ideas that will only bear fruits in the future. In your system, the same might be achieved in equal measure through an equity market that probably provides similar avenues for asset bubbles to develop, without pricking it soon enough due to the very nature of equity capital and limited liability.

    As I understand it, the simplified system is a way to eliminate profligate credit and profligate derivatives. The aim, I presume, is to reduce the risk of complexity. Wouldn’t this be achieved to a large degree simply by the elimination of credit derivatives, while still allowing for most historical financial innovations.

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