Saturday, October 6, 2012

How the financial system works

It’s amazing to think the mighty, mysterious, overawing edifice of high finance - run by people much smarter and infinitely better-paid than us - is built on a pathetically simple, often fickle emotion: trust.

This is something economists and bankers understand in theory but, in their world of high-falutin’ mathematical models, keep forgetting in practice - to everyone’s cost. In this they exhibit the very human fallibility they so often assume away in their fancy calculations.

It’s also so elemental - and so humbling - they rarely talk about it. So when someone in authority spells it out for the benefit of mere mortals, it’s work taking note. An assistant governor of the Reserve Bank, Dr Guy Debelle, did so in a speech last week.

He started by explaining what banks and the financial sector do. They act as ‘intermediaries’ between savers and borrowers, taking the funds they raise from savers - through deposits, for instance - and lending them to those who wish to borrow, whether they’re businesses, governments or householders.

The financial sector is an intermediate sector, Debelle says. It’s not at the end of a production chain producing something that directly generates satisfaction. Rather, it’s a critical link along the way; the oil that keeps the economy ticking over. ‘When the oil dries up,’ he says, ‘the economic engine starts to malfunction and can ultimately grind to a halt.’

So the financial sector is different from other parts of the economy and its central role in keeping the rest of the economy functioning explains why it’s subject to considerably more government regulation and oversight than other industries (something many governments forgot in the years before the global financial crisis).

But why do we need financial intermediaries? Why don’t savers lend to borrowers directly? Mainly because of ‘asymmetric information’. This just means I know more about my affairs than you do. It’s hard for a saver to know whether the person or business to which they’re going to lend money will use the money wisely and be in a position to repay the loan when it falls due.

In contrast, a bank is practiced at making such an assessment of credit-worthiness and so can reduce (but never eliminate) the degree of asymmetry. The size of the interest rate charged by the bank should reflect its assessment of the degree risk of not being repaid.

The other main advantage of lending via intermediaries is their scope for ‘diversification’ - making a range of different loans to people or firms in different circumstances means the bank should not be overly exposed to a particular loan going bad.

So banks are able to ‘mutualise’ risk in a way individual savers can’t. ‘If there is a problem with one loan, the lender should be earning sufficient interest on the rest of its loan portfolio to cover the loss,’ Debelle says.

Now we see where trust comes into it. Largely because of the problem of asymmetric information, there has to be trust between depositors and the bank that their funds are safe. And there is trust between the bank and its borrower that the borrower has provided accurate information and will act in good faith.

Trust is needed to cover the asymmetry that remains despite the ‘due diligence’ of the depositor in assessing the riskiness of the bank and of the bank in assessing the riskiness of the borrower.

Trust is particularly important because banks engage in ‘maturity transformation’ - in the jargon, they ‘borrow short and lend long’. Banks will let you deposit your money ‘at call’ (you can withdraw it at any time) but, on the other hand, will lend this money for periods up to 30 years.

Were too many depositors to lose trust in their bank at the same time, it would not be able to call in all its loans and so would not be able to return the depositors’ money. To prevent such a thing occurring, central banks stand ready to lend to banks if they need it. The trust in these arrangements is almost always enough for them not to be needed, Debelle says.

Banks don’t always hold on their own books all the risk (debt) they’ve taken on, but use devices such as ‘securitisation’ (bundling many consumer loans into a bond, which is then sold to investors) to distribute the risk around the financial system.

This means the process of financial intermediation often has a number of links in the chain. This, in turn, means trust needs to be present at every stage in the chain. ‘One breakdown in this chain of trust between ‘counterparties’ can throw a spanner in the works of the whole process,’ he says.

Guess what? The global financial crisis can be explained as a consequence of the breakdown of trust.

The years leading up to the crisis were a period of what Debelle calls ‘lazy trust’. Things were going along fine, so too many people relaxed their due diligence. Too many borrowers were taken at their word, without checking.

‘Moreover, with long chains of intermediation involved, there was often too much distance between the ultimate holder of the risk and the source of the risk. Too many links means that details get lost or misheard. If the due diligence is necessarily incomplete by the very nature of financial transactions, then that incompleteness is likely to get magnified, the more chains there are in the transaction.

‘The due diligence gets dissipated along the chain. There is a presumption that someone further up the chain did the due diligence.’

Such behaviour was anything but rational. As Debelle concedes, ‘good times beget complacency’. ‘It does seem to be a trait of human behaviour that has been evidenced many times in financial history.’

Lazy trust evaporated. The financial system switched rapidly from complacency to deep mistrust. In particular, trust broke down between financial institutions. Knowing they had a lot of bad loans on their own books, institutions assumed the same was true of their competitors, though to an unknown extent.

Institutions stopped lending to each other, so intermediation broke down. Central banks had to step in and provide banks with the funds they needed. This is still true in Europe, and a lack of trust in the longevity of the euro has made people unwilling to lend even to some governments.

The trouble now is that trust can be quickly and easily shattered, but takes a long time to rebuild.