Structured finance needs fixing

John K Galbraith, like many left-wing critics of capitalism, has a keen eye for interesting facts. It is gross credit excess that is fueled the recent stock market bubble. The obverse side of credit is debt, and that is precisely where the problem rises. As credit expands, debt expands with it, especially bad debt. Eventually, the bad debt leads to a crisis; if a sizeable amount of debt cancellation occurs, you get deflation and a crisis of epic proportions.

Then I read this piece by Dr.Alok Sheel in ET. He figures amongst the rare breed of civil servants with a very sharp mind.

“Driven by complex mathematical engineering securitized structured finance is a modern financial marvel that has deepened capital markets through greater dispersal of risk, contributed to higher growth by intermediating access to large amounts of low-cost funds generated by global imbalances, and made development more inclusive by giving previously excluded groups access to assets like residential property. It has also spawned a new breed of highly paid graduates well versed in mathematics and calculus, but alas, quite divorced from the real world of old-fashioned finance with its putative sixth sense of sniffing out risk through a deep appreciation of human psychology, market sentiment and moral hazards.

In A Short History of Financial Euphoria, Galbraith advanced the rather depressing theory that finance did not lend itself easily to innovation, since at the end of the day all credit is secured on some asset, no matter how much it is repackaged and sliced. It is undoubtedly true that excessive liquidity that went beyond what would be expected based upon existing assets was a necessary condition underlying the subprime crisis.”

It’s a long article. I’d distill a few steps outlined in there –

a) Basle capital adequacy norms should limit off balance-sheet exposures. This should help confine contingent risks to the originating bank, though there could be some shrinkage in credit supply.

b) The originating bank could be required to retain a ‘fraction’ of the original portfolio (“fractional banking”). This would address the moral hazard inherent in the ‘originate and distribute’ lending model where there is little incentive for the loan originator to adhere to prudential lending and monitoring standards.

c) The Basle norms to address liquidity risks arising from maturity mismatches. This risk is presently handled through state-funded deposit insurance and central bank/ government bail outs. Universal banking also faces liquidity risks arising from positions taken in (non-money creating) investment. The subprime financial crisis was not escalated by large-scale loan defaults but because assets became illiquid as credit markets simply froze. Short-term debt raised to fund long-term investments could not be rolled over.

d) Review the banking business model. Presently the traders split a good slice of profits as commission but in case of a loss, they kick it back to the shareholder. Adopt the private equity model where the players, having a more direct stake, move nimbly to hedge their positions better.

e) Regulate the regulators.