Sunday, October 12, 2008

Thoughts on banking

Prof. Jayanth Varma seems to hold a view similar to what I wrote in the previous post. Securitization has little to do with the current crisis. Here's the link. Ofcourse, a fiasco like AIG probably wouldn't have happened but for the misuse of Credit Default swaps. However, it isn't wise to pin the blame on CDS product per-se, especially when the infrastructure to support it is inadequate. The CDS market is mostly OTC. In the absence of an exchange that bears counterparty risk and ensures liquidity, credit derivatives were unlikely to be successful.

The professor's remarks on the basic unsoundness of a bank driven financial system were quite provocative. Ideally, a credit intermediary would want to borrow long and lend short (who wouldn't!). However, no saver wants to lend long and no investor wants to borrow short. As a result, the banking system is forced to resort to very high leverage levels to make its business model viable.

Now, the most facile solution is to do away with credit intermediaries (banks) and move towards a world where credit allocation happens entirely through financial markets. Securitization is a step in that direction. In an idealized version of that world, every credit-seeker, be it an individual or a business, will issue a bond. The prospective lenders will make the investment decision based on the borrower's creditworthiness (say his FICO score). Sounds very good.

However, there is a hitch. For such a system to function, it is important that we have borrowers and lenders who are willing to borrow and lend respectively over an identical timeframe. That's seldom the case since most reasonable people want to borrow long and lend short. Which is why we have highly risky institutions called banks with humongous leverage levels :(

To do away with banks would imply a considerable shrinkage in the economy's capacity to supply credit to those who need it. To persist with them would mean many more financial crises similar to what we're witnessing.



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