Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Simplified Finance: Part III

In my last two posts on this subject, I talked about how a
simplified financial sector would look like. Part I presented an ultra simplified financial sector with a payment system, a stock exchange, “narrow” insurance companies and practically nothing else. I argued that this system with no banks, no debt and no central banks would do a reasonably good job of supporting economic growth provided high levels of corporate governance could be
enforced. Since that was unlikely to happen, Part II introduced long term corporate debt but still avoided banks. The difficulty here was that debt would not be available to smaller enterprises.

What happens when we introduce banks or bank like entities? To
understand this we must recognize that corporate debt is already a
derivative contract – because of limited liability, debt is
economically the same as a put option on the assets of the company. If the value of the assets is less than the amount of debt, the company default and the assets belong to the creditors. This is economically equivalent to the shareholders selling the assets to the creditors at a price equal to the amount of debt. This is nothing but a put option. So the model of Part II had derivatives already though they were not described as such.

In part II, the toxicity of these derivatives was reduced by two
means – first by allowing only long term debt and second by
requiring this debt to be bought directly by individuals and not by
financial intermediaries. The effect of this restriction would be to
reduce the quantum of the debt and thereby reduce the amount of
derivatives floating around in the economy. The low leverage also
avoids the need for corporate hedging.

Once we introduce banks, we would also have to bring in short term debt since the assets and liabilities of the banks would be short
term. The presence of banks as well as short term debt would encourage companies to take on higher levels of leverage to benefit from the interest tax shield. This makes corporate risk management
essential.

More troubling is the risk management of the banks themselves. A
bank is nothing but a CDO as I argued
more than three years ago (see also this entry) – it is a portfolio of debt securities. The probability distribution of a credit portfolio is
extremely skewed and fat tailed even if the values of the real assets
are normally distributed. (Vasicek derived this so called normal
inverse distribution way back in 1997). If the real assets themselves
have fat tailed distributions and display non linear dependence
patterns, the distribution of the credit portfolio is even more
toxic. To manage the toxicity of this distribution, the bank has to
use various risk management tools.

An economy with free floating exchange rates and interest rates
must provide its banks (and leverage companies) with interest rate and currency derivatives. This presents us with a trilemma – (1) the economy can operate with fixed exchange rates and administered (repressed) interest rates or (2) it can run without banks and leveraged companies or (3) it can create derivative markets. In terms of financial innovation we cannot roll the clock back to the 1970s without also restoring the world economic order of the early 1970s

In all this, I have not talked about credit to individuals at all
because it is possible to visualize a fairly advanced economy in which
there is no consumer credit at all. It is possible to argue that the
economic benefits of retail credit is quite small. Most of retail
credit is for housing and as I argued in Part I, there is little economic reason for people to own the houses that they live. From the days when the suffrage was limited to those owning immovable property, home ownership has been a political question rather than an economic one. Most of the other consumer credit (credit cards and credit for consumer durables) is taken by those who are less than fully rational.

While economists talk about consumption smoothing, very little of
consumer credit actually performs this function. The only important
consumer credit in my opinion is the educational loan which allows
investment in human capital. This is potentially as important as
credit to businesses (which allows investment in physical capital),
but as I argued in Part I, there are other equity like solutions to
this problem as well.

A financial system without a mortgage market at all would not have encountered the crisis of 2007 and 2008 which have been rooted in the mortgage markets. But it would not have been immune to crises. Financial history teaches us that exposure to commercial real estate and to over-leveraged companies can create banking crises without any help from mortgages or from any other financial
innovation.

In short, creation of banks and other pools of credit is the most
toxic financial innovation ever but there might be good reasons for
living with the consequences of this toxicity.

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