As I’ve said before, I think many liberals are underrating the extent to which both the House reg reform bill and the Dodd reg reform bill will, in fact, do a lot to help prevent future bailouts and panics. At the same time, it’s quite true to say that these proposals don’t appear to do much of anything to address broader concerns about the role of modern finance in the American economy.
Today, for example, I spent some time with Andrei Schleifer and Robert Vishny’s “Unstable Banking” in which they attempt to explore the question of whether anything socially beneficial has arose from widespread securitization. They construct a coherent model in which the answer is no:
In this model, banks that cannot securitize loans smooth their lending over time. When banks participate in financial markets, however, they respond to investor sentiment. Banks use their scarce capital to co-invest in newly securitized loans when asset prices are high, and to buy or hold onto distressed securities when asset prices are low. Expanding the balance sheet to securitize is so profitable in good times, however, that banks borrow short term and accept the risk of having to liquidate their portfolio holdings at below fundamental values in bad times. Such liquidations further destabilize security prices. By stretching their balance sheets to the limit in good times, banks give up the opportunity to finance investment or buy distressed assets in bad times.
Under these circumstances, bank profits and balance sheets, as well as real investment, are highly cyclical. Investment is strictly higher with securitization than without it, but may be distorted in favor of projects available for securitization during bubbles. This can reduce efficiency even without any costs of cyclical fluctuations. The central message is that financial intermediation transmits security market fluctuations into the real economy; the volatility of sentiment turns into the volatility of real activity.
The important conclusion here is that the impact of this volatility is bad even apart from any potential costs of a crisis. The inefficiency comes about simply because everyone is willing to finance investments all at the same time, and then everyone is unwilling at the same time. Absent securitization, banks can only lend so much during the boom and thus have a limited ability/incentive to cut back during the downturn. With securitization, that changes and reasonable projects have difficulty getting funding during the downturn. Which, in turn, makes it harder to return to growth.