Arnold Kling  

What Are Good Financial Institutions?

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An interesting dialog between Dani Rodrik and Steve Randy Waldman. Some excerpts from the latter:


The purpose of a financial system is to solve a collective optimization problem whose solution we cannot guess a priori. If we are very sure that welfare is maximized by vastly expanding the housing stock and making homeowners of people who otherwise might not buy, then the government should just tax to build McMansions, and auction off the oversupply. More generally, one cannot judge a financial system by any particular outcome, because all financial systems make mistakes, and the mistakes always look good while they last. We judge financial systems by the performance of the economies they guide over time.

...Savers should not be investors, that is they should not be underwriting the execution of projects about which they have no opinion and whose risks they are unwilling to bear.

...Complexity is much more often a marker of snake-oil than of quality in a financial instrument. "Sophisticated" investors are almost always predators or fools. The real-world informational problems investors face -- what is it that should be done? how ought our resources be deployed? -- are challenging enough. Creating structures that cannot be understood except by applying complex models that may or may not adequately capture the behavior of the instrument is just idiocy, a mish-mash of quant hubris and pseudoscientific salesmanship.

He says much more, not all of which I agree with.

You cannot simply say, "We must have transparency." Requiring transparency means requiring people to disclose information that is costly to acquire. But that undermines their incentive to acquire information.

Take my example where the investment projects are fruit trees with susceptibility to disease. Suppose that it is costly to assess the soil in a particular area for its ability to nourish the trees so that they can avoid disease. If you force anyone who discovers information about the soil to be "transparent" and to disclose that information, people will not undertake investments to obtain the information.

Instead, what you need are incentive-compatible contracts. The entrepreneur who knows a lot about the soil offers a debt contract, which in effect tells the investor "I can promise you that the soil is at least good enough to enable trees planted here to pay off the debt." To make this incentive compatible, the entrepreneur puts a lot of his own wealth into the fruit tree project and retains a residual claim in the form of equity. Because of his equity stake, the entrepreneur loses if he overstates the value of the soil to the investor to whom he issues debt.

From this perspective, a good financial institution is one which encourages people to gather and use information in an incentive-compatible way. A bad institution promotes misinformation, typically because of problems with incentive compatibility. It could be that the vast majority of financial activity that we take for granted in the economy takes place within the context of what I would consider bad institutions.

Why do bad institutions survive? It could be that it is very difficult to learn what is a bad institution,, except through painful experience.

However, I suspect that the main reason we have bad financial institutions is that individuals are irrational. I can well imagine that it is easier to market a Ponzi scheme (suitably dressed up) than an incentive-compatible financial contract. People think they are smarter than they really are. As a result, bad financial institutions satisfy customer demand, just as politicians offering free lunches satisfy voter demand.

The issue of financial regulation is whether it tempers bad financial institutions or reinforces them. In my judgment, it does a lot of both. There are a lot of regulatory actions that serve to stop Ponzi schemes. However, there are other regulatory actions that encourage Ponzi schemes. I keep coming back to risk-based capital requirements, which were well intentioned but in fact had the perverse impact of promoting securitization of high-risk mortgages over the origination and holding of low-risk mortgages.


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COMMENTS (6 to date)
E. Barandiaran writes:

(comment deleted for inappropriate tone. insults of third parties are not appreciated)

manuelg writes:

> You cannot simply say, "We must have transparency." Requiring transparency means requiring people to disclose information that is costly to acquire. But that undermines their incentive to acquire information.

> However, I suspect that the main reason we have bad financial institutions is that individuals are irrational. I can well imagine that it is easier to market a Ponzi scheme (suitably dressed up) than an incentive-compatible financial contract. People think they are smarter than they really are. As a result, bad financial institutions satisfy customer demand, just as politicians offering free lunches satisfy voter demand.

Thank you for writing this. I am a Liberal/Socialist/Commie, but I greatly appreciate this view being intelligently expressed, right now.


Greg writes:

Regarding capital requirements promoting securitization of high-risk mortgages, that does seem like a good example of unintended consequences. But in my mind, the problem is the loopholes in the requirements rather than their existence. And why did firms choose to securitize high-risk mortgages rather than low-risk ones?

This points back to the dramatic failure of firms to recognize risk. This is a huge market failure rather than regulatory failure, and I think you might be underestimating it. Just consider the thought process: Housing in different regions has tended to be uncorrelated in the past, so let's combine all these mortgages to arrive at low-risk securities. These securities will then become a national market, but this development will not cause any correlation. We can continue to assume that all the risk is averaged out, and we can assume that our investments will never lose value. Additionally, companies like AIG can assume that their insurance on these products will never be needed. Wow. This is just an enormous market failure, and I get the impression from your posts that you gloss over this in favor of focusing on the perverse effects of government intervention and regulation of this market.

floccina writes:

If we are very sure that welfare is maximized by vastly expanding the housing stock and making homeowners of people who otherwise might not buy, then the government should just tax to build McMansions, and auction off the oversupply.

If we were very sure that welfare was improved by making more people homeowners we could build smaller cheaper homes.

This whole more loans idea is a silly way to increase home ownership. Now if you wanted people to be able to consume more home at a younger age when they can enjoy it more then you have a case.

fundamentalist writes:

Here is Joe Stiglitz over at the Economist debate on regulation:

Crises are caused by banks having too much leverage. They face an “inflexibility trap” and “negative convexity”. Generally, a shock occurs, a “fat-tailed event”, and as a result a bank suffers a loss on a product line such as subprime mortgages that, in turn, requires it to reduce the risk of its equity. To do so, it must issue additional equity or sell risky assets to pay back debt. With leverage, to reduce risk needs action. If the bank attempts to raise equity capital, however, it faces the “inflexibility trap”. By issuing equity, debt holders have more capital supporting their debt and are better off. Equity holders must be worse off. That is, on the announcement of the offering, the price of existing shares fall. This follows from option theory. When governments infuse capital into banks, the new capital benefits the debt holders. This is the true “moral hazard”.
The simple remedy, therefore, is to require banks to have less leverage or—its converse—to have additional equity capital. This garners flexibility. And flexibility is valuable. It is an option. We can measure its value and price it accordingly. If society is to provide the option, it should charge for it in advance, and then it becomes the supplier of contingent capital to the financial system. This creates the correct incentives. This is not regulation; this is economics.

fundamentalist writes:

I'm sorry! That quote was from Myron Scholes, not Stiglitz.

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