Reply #6: Financial Innovation Takes the Homework Out of Banking

[Demeter]

http://yglesias.thinkprogress.org/archives/2009/04/financial-innovation-takes-the-homework-out-of-banking.php

I got a mortgage back in October and found myself a bit taken aback by how little was involved in it. I gave some information about my income, about the size of the loan I wanted, and about my credit rating. Then in went a formula and out came approval. If someone was asking me for a big loan in the middle of a recession, I would want to know more. Like what’s the guy’s employment situation? Are there decent odds he might get laid off and have his income drop to $0? I think I could have mounted a strong case that layoffs at CAP were very unlikely (too much voluntary attrition of people going to work in government post-election) but nobody asked.

Now say what you will about this, but the lack of detailed inquiry into the situation definitely made it easier for me to get the loan. And not even because a detailed inquiry would have wound up with me getting declined. It just spared me some hassle. But like Ryan Avent I have to wonder if this is really a good thing:

A lot of recent financial innovation has been defended on grounds that it improved the flow of credit or made credit easier to obtain. But increasingly it seems that it did this by allowing everyone to stop doing their homework. Magical de-risking processes made the need to do homework before investing unnecessary. Magical hedging formulas did the same thing, and saved lenders the trouble of caring when a borrower got in trouble. The financial system became like a fancy new car — full of top-of-the-line safety features, traction control, ABS, and so on. And like drivers who seem so effortlessly in control and completely safe that they forget how deadly two tons of steel traveling at 80 miles per hour can be, market participants were lulled into forgetting how dangerous finance can be.

This seems to me to be related to some of the issues about the scale of financial institutions. To a certain extent, bigger size makes you a better lender because you’re more able to manage risk. If someone offers Google to flip a coin, with Google getting $2 million if it comes up heads and Google losing $1 million if it comes up tails, Google will take the bet—the odds are great and they’ve got a ton of cash. But offer me the bet and I’ll have to turn it down. I can’t afford to lose $1 million even on good odds.

But the flipside of this is that when institutions get really big they can’t really be doing much homework. An old-school local bank can expect the people supervising loan applications to have specific knowledge about situations. And perhaps more importantly, the head of a small institution can directly monitor what his subordinates are doing. And while he perhaps can’t have detailed information about everything that’s going on, he can have general knowledge of the local economic situation.

But when I got my mortgage from Bank of America, it’s not like there was some plausible worry that Ken Lewis was going to knock on the guy’s door unexpectedly and make sure that everything was being done right. You can’t really have a homework-based system at a giant institution. Things need to be handled through bureaucratic processes and rules and formulae.

In the real world, of course, anything’s going to fall on a spectrum between homework-based risk-assessment and formula-based risk assessment. Innovation, in large part, looks to have been a process by which an institution could claim to be able to viably shift further toward the formula-based side of the spectrum. That, in turn, could justify larger firm size since less monitoring was now necessary. And larger firm size leads to larger executive pay packages. It also leads to a larger amount of safe leverage if you assume you’re not increasing the amount of risk by doing less homework and that also means larger pay packages. And the lure of bigger salaries seems to have been enough to tempt management into papering over problems with the underlying theory.

Then underlying how you evaluate this trend from a policy perspective depends to some extent on underlying economic theory. According to a prevailing brand of neoliberal rationalism, if firms were all trending in one direction then the fact that the trend was happening was sufficient proof that it’s a good idea. After all, if it wasn’t a good idea then the market would price the badness of the idea into the firms’ share prices and that would have caused the trend to turn around. That’s a nutty way of looking at the world, but that seems to have been the prevailing view of policymakers for most of the past 20 years.