by Constantin Gurdgiev, TrueEconomics.Blogspot.in
This post appeared originally at true economics, 04 January 2017.
The truth about the traditional banking model: it is dead. Ok, to be temporally current, it is dying. Six reasons why.
1) Banks can’t price risk in lending – we know as much since the revelations of 2007-2008. If they cannot do so, banks-based funding model for investment is a metronome ticking off a crisis-to-boom cyclicality. That policymakers (and thus regulators) cannot comprehend this is not the proposition we should care to worry about. Instead, the real concern should be why are equity and direct lending – the other forms of funding – not taking over. The answer is complex. Informational asymmetries abound, making it virtually impossible to develop retail (broad) markets for both (excluding listed equity). Tax preferences for debt is another part of the fallacious equation. Habits / status quo biases in allocating funds is the third. Inertia in the markets, with legacy lenders being at scale, while challengers being below the scale. Protectionism (regulatory and policy) favours banks over other forms of lending and finance. And more. But these factors are only insurmountable today. As they are being eroded, direct financing will gain at the expense of banks.
The side question is why the banks are no longer able to price risks in lending, having been relatively decent about doing so in previous centuries? The answer is complex. Firstly, banks are legacy institutions that have knowledge, models, memory and intellectual infrastructure that traces back to the industrial age. Time moved on, but banks did not move on as rapidly. Hence, today’s firms are distinct from Coasean transaction cost minimisers. Instead, today’s firms are much more complex entities, dealing with radically faster pace of innovation and disruption, with higher markets volatility and, crucially, trading in the environment that is more about uncertainty than risk (Knightian world). Here, risk pricing and risk management are not as closely aligned with risk modeling as in the age of industrial enterprises. Guess what: if firms are existing in a different world from the one inhabited by the banks, so are people working for these firms (aka banks’ retail customers). Secondly, banks’ own funding and operations models have become extremely complex (see on this below), which means that even simple loan transaction, such as a mortgage, is now interwoven into a web of risky contracts, e.g. securitisation, and involves multiple risky counterparties. Thirdly, demographic changes have meant changes in risk regulation environment (increased emphasis on consumer protection, bankruptcy reforms, data security, transparency, etc) all of which compound the uncertainty mentioned above. And so on…
