The Next Financial Crisis and How to Save Capitalism

H. Askari, A. Mirakhor

• Publisher: Palgrave Pivot
• Year: 2015
• ISBN:
  9781137544377
• Topic: Commerce
• Subtopic: Services financiers

The financialization of the economy has brought a number of interrelated problems which have contributed to growing income and wealth inequality. Askari and Mirakhor assert that it is time to make a bold change by putting our financial house in order and on a better path, advocating for a fundamental reform of the financial system.

1

The Financial Sector—In Support of Growth or Financialization?

Abstract: A stable and efficient financial sector has an essential role in support of the real sector to facilitate mechanisms for an efficient allocation of financial and real resources by funding the investments with the highest social rate of return: mobilizing savings, identifying the best business opportunities, financing these investments, monitoring their performance and their managers, enabling the trading, hedging, and diversification of associated risks, and facilitating the exchange of goods and services. Financial institutions, by pooling risk, should be better positioned to analyze investments and their associated risk-return profile and to monitor the performance of investment projects. Our financial system has achieved some of these goals but has also been accompanied by recurring crises.

Keywords: finance; financialization; intermediation; investment; risk; savings

Askari, Hossein and Abbas Mirakhor. The Next Financial Crisis and How to Save Capitalism. New York: Palgrave Macmillan, 2015. DOI: 10.1057/9781137544377.0006.

Introduction

The primary role of a financial system is to create incentives and mechanisms for the best allocation of financial resources with minimum waste or maximum output (efficiency) in an economy through time. In other words, an ideal financial system would facilitate the financing of the “best” investments, or the investments with the highest social return or payback, by identifying the best business opportunities, mobilizing savings, funding these investments, monitoring the performance of the selected investments and their managers, enabling the buying and selling ownership in these investments (trading), locking in a known return (hedging), providing ways to diversify associated risks, and facilitating the exchange of goods and services between producers and consumers throughout the economy. Within a financial system, financial markets (where buyers and sellers trade currencies and the three principal financial instruments, namely, stocks, bonds, and derivatives or contracts whose value is derived from the performance of the asset on which it is based) and banks facilitate the vital functions of raising capital and channeling it to entrepreneurs and companies (capital formation), monitoring, information gathering, and facilitating the sharing of risk. To the extent that financial markets perform these crucial tasks efficiently, individuals are spared these responsibilities and the attendant costs of channeling their savings into rewarding investments.

In further elaboration, an ideal financial system should perform a number of functions. First, the system should facilitate the efficient channeling of savings from savers to investors (financial intermediation) to reduce information gathering and allocation costs for individuals by spreading these costs among many individuals and providing them with the broad range of financial instruments and investments that they seek. It would be prohibitively expensive and wasteful for every individual to analyze the attractiveness of investments and invest in such a way as to get the type of investment that he or she wants (debt or shares, short term or long term, and size of minimum investment). Intermediaries can do all this on behalf of many individual investors by spreading the cost of information gathering and reducing the fallouts of information asymmetry between parties to an investment (adverse selection and moral hazard) by better assessment of borrowers’ risk and subsequent monitoring of borrowers’ performance. Moreover, as Crockett (1996) noted commercial banks by pooling risk can afford depositors’ attractive returns as well as the ability to redeem their deposits quickly (enhanced liquidity). Second, with increasing globalization and demands for financial integration, it is essential that the financial system offer efficient and liquid markets for trading assets with short maturities (Money Markets) and markets for channeling capital to governments, businesses and individuals (Capital Markets). And third, the financial system should provide a well-developed market for risk trading, where economic agents can buy and sell protection against unforeseen developments such as fire (event risk) as well as all forms of financial risks (such as sharp declines in share prices and interest rates).

These functions ultimately lead to the efficient allocation of resources, rapid accumulation of physical and human capital and faster technological progress, all of which, in turn, stimulate economic growth. A sound financial system should be stable, reduce uncertainty, and provide the basis for rational decision making to stimulate savings and investment. While stability is desirable, it must not impede price flexibility (such as changing interest rates) that signals change to market participants but avoid excessive volatility that emanates from excessive speculation and uncertainty (Crockett). It should be evident that an efficient, sound, and stable financial system would be essential for promoting savings, funding the best investments and in turn fueling economic growth and prosperity. Thus the financial sector should support the real economy to function more efficiently, while providing a broad array of investment instruments with different liquidity-risk-return profiles and a market for trading risk.

In recent years, it has become widely recognized that debt, loans or borrowing through interest-based contracts and a banking system that creates money from deposits and bank lending invariably promotes a phenomenon that has become coined “financialization,” resulting in a growing divergence between the real and the financial sectors of the economy, or in other words tethering the linkage between the real and financial sectors. To the extent that the financial sector simply produces more financial instruments and promotes their trading, it does not perform its vital function of encouraging savings and funding the best investments. If this were the case, then real economic growth would be impaired. How can this decoupling of the real and financial sector come about? Interest-based debt contracts have a tendency to shift risk onto those who cannot manage it and the end result is excessive debt buildup and widespread defaults; the borrowers can be individuals or businesses that borrow too much relative to their capacity to pay the contractual interest payments and pay back the principal.

The conventional banking system, or what is commonly referred to as fractional reserve banking with banks creating demand deposits (checking accounts that is a form of money) and then lending a large portion of their customers’ deposits, results in the expansion of the money supply through demand deposit creation (a form of money as checks are money) and creating more and more debt or what is generally referred to as leveraging. Simply said, when a depositor deposits $100 in a bank, he or she has access to the money in the form of check-writing capacity; his or her money (dollar bills) is there but in the form of checks (or cash if the depositor needs cash). The bank created money by giving checks to the depositor and then lending out a large fraction (say 80 percent) of the depositor’s cash; the borrower from the bank then deposits his or her borrowed money in another bank, the bank issues a checking account and then lends 80 percent of these new deposits; and the process goes on and on. Note that the original depositor’s cash was transformed into demand deposits (a promise by a bank to honor checks up to the amount that is in the account) and the banking system created money by lending the money that was entrusted to it for safekeeping.

But banks would like to lend out more and more in order to make more profits. Their dreams were answered by the development of complex financial instruments, such as derivatives or financial instruments that derive their value from an underlying asset and securitized debt or loans that are bought from a lender (such as a bank) and then used to issue shares to investors with these loans as their backing. These innovations further encouraged credit expansion (enabling banks to lend even more) to outpace the growth of the real sector of the economy. As financial assets are securitized and resecuritized (debts, such as mortgages, are bought from banks, packaged, and sold as new securities that pass on the mortgage interest to the buyers of the created securities), the banks get cash for their mortgages or car loans and then they lend their cash out again. Disproportionate risks are transferred through derivative instruments, the connection between the financial and real sectors becomes decoupled (the financial sector growing much faster than the real sector), and an inverted credit pyramid is created where the liabilities of the economy become a large multiple of real assets (the base of the pyramid) that support them.

Mismatched assets and liabilities are another characteristic of such a banking system. Namely, a bank’s loans are largely medium and long term but its funding is short term, from checking and savings deposits and certificates of deposit (CDs). Deposits are very short term because depositors can retrieve their deposits at a moment’s notice and CDs are normally short or medium term and can be cashed with a penalty. There is a mismatch because the maturity of their loans is long term whereas the maturity of their funding is short term. If depositors demand cash for their deposits, a bank can be caught short as it cannot immediately liquidate its investments and call in its loans to honor its commitment to depositors. Although the bank may be still solvent, such a squeeze can pose a danger, requiring the government, or a government agency, to step in and make cash available to banks on a short-term basis. But price shocks can be more of a problem. For instance, if a bank has made long-term loans and invested in long-term government and corporate bonds, then with a sharp decline in the value of its loans and investments (from a sharp decline in price or bankruptcy) it may be insolvent as the liability side of the balance sheet is very slow to adjust while the asset side has declined rapidly. Such mismatches create a potential for instability that can spread rapidly through the interlocking connection of financial institutions, with many institutions being both borrowers and lenders exposed to the risk of rapid price changes and defaults. The result can be an increase in the frequency, transmission and severity of financial and economic crises, with the resulting economic crises being more severe than ordinary recessions because the financial industry has a widespread impact on all sectors, including households.

Between 1980 and 1995, 35 countries experienced some degree of financial crises. These were, essentially, periods during which their financial systems stopped functioning and, consequently, the real sectors were adversely affected leading to economic downturns or recessions. Recent research on financial intermediation and financial systems has enhanced our understanding of why the financial system matters and the crucial role it plays in economic development and growth. For example, studies have shown that countries with higher levels of financial development grow by an additional 0.7 percent or so per year. Although strong evidence points to the existence of a relationship between a well-developed financial system that promotes efficient financial intermediation (through a reduction in information, transaction, and monitoring costs) and economic development and growth, this linkage and the direction of causation is not as simple and straightforward as it may at first appear.

Financialization

Financialization means different things to different people. The 2007–2008 financial crisis has been explained by some as a culmination of a long process of “financialization” of the advanced industrial economies that was left unchecked, despite numerous warnings during the previous three decades. Financialization has been defined in various ways that emphasize three basic elements or characteristics: (i) a significant expansion of the financial sector relative to the real sector, such as increasing the financial sector’s share of GDP, increasing the share of financial sector profits relative to total corporate sector profits, higher rate of return on equity in the financial sector relative to return in the rest of the economy, and the like; (ii) a fast expansion of financial institutions and products outside traditional banking and traditional instruments, without which financialization could not have thrived; and (iii) an expansion that was not beneficial to the broader economy and may have even turned out to be harmful for longer-term economic growth. To some observers, besides bringing on the worst financial crisis since the Great Depression, the economic consequences of financialization may also be summarized as: a drop in the share of wages and nonfinancial profits in national income, a consequent drop in real capital investment in the nonfinancial sectors of the economy, tepid economic growth of the real economy, heightened speculation, increasing numbers of bankruptcies and economic distortions, significant economic and financial uncertainty, and increased social inequities including a worsening of income and wealth distributions.

In the United States (and in other major Western economies) the financial sector has been partitioned over the past 30–40 years. The financial system embraces on the one hand traditional instruments such as shares and bonds, and on the other hand nontraditional instruments such as financial derivatives. The system includes deposit taking by a traditional banking, such as or commercial banking and nondeposit shadow banking, which includes money market funds, institutional investors, hedge funds, mutual funds, private equity funds, mortgage companies, and insurance companies. The competition for financial resources (such as deposits) and for income opportunities between traditional and unregulated financial intermediaries have become intense, leading both segments of the financial system to devise innovations that increase their access to resources and their income-earning assets, and at times promoting unwarranted speculation and risk taking on their own and on their clients’ account.

Financialization has fueled an explosion of financial activities in the form of nonregulated financial institutions and a phenomenal growth of financial engineering and complex financial products, incorporating the power of creating money through debt (leveraging) with little regard for its attendant risk. Besides its traditional and beneficial role of intermediation between savers and investors, financial institutions ventured into trading and speculating in risky financial instruments on their own account (proprietary trading) and speculation and in the process became dangerously overleveraged. Financialization has also led to the development of shadow banking, securitized or parallel banking, with the purpose of increasing the availability of resources for the traditional banking sector. This shadow banking includes: (i) bank conduits, namely, special investment vehicles (SIVs), special purpose vehicles (SVPs), and limited purpose finance corporations (LPFCs) and (ii) securitizations that cover asset-backed securities (ABSs), asset-backed commercial papers (ABCPs), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), auto-loans-backed securities, collateralized loans obligations (CLOs), collateralized bond obligations (CBOs), and collateralized debt obligations (CDOs). Derivatives such as credit default swaps (CDSs) were invented in order to spread credit risk and push traditional banks into higher risk lending and related activities. Securitization has created derivatives based on existing debt with the purpose of increasing lending activities. However, securitization has also turned into the practice of selling toxic loans to investors using fraudulent practices. Opacity has replaced transparency and investors can no longer know the “fair” price of the securities they are buying or selling.

In short and more broadly, financialization is a process whereby financial markets, financial institutions and financial elites gain greater influence over economic policy and economic outcomes. Financialization transforms the functioning of economic systems at both the macro and micro levels. Again, its principal fallouts are to (i) elevate the significance of the financial sector relative to the real sector; (ii) transfer income from the real sector to the financial sector; and (iii) as a result increase income and wealth inequality and contribute to wage stagnation. In addition, there are reasons to believe that financialization may put the economy at risk of debt deflation and prolonged recession. To Epstein (2005) financialization refers to the increasing importance of financial markets, financial motives, financial institutions and financial elites in the operation of the economy and its governing institutions, both at the national and international level. Krippner (2005) defined financialization as a pattern of wealth accumulation in which profit making occurs increasingly through financial channels rather than through trade and commodity production. Palley (2007) contended that the notion of financialization covers a wide range of phenomena: the deregulation of the financial sector and the proliferation of new financial instruments, the liberalization of international capital flows and increasing instability in foreign exchange markets, a shift to market-based financial systems, the emergence of institutional investors as major players on financial markets and the cycle of boom and bust on asset markets, shareholder value orientation and changes in corporate governance of nonfinancial business, increased access to credit by previously “underbanked” groups or changes in the level of real interest rates.

We add that when a financial sector is dominated by interest-rate-based debt contracts, the financialization process creates more and more debt as it expands throughout the economy, converting equity in real assets into debt. This was the case in the early stages of the housing boom in the United States where excess liquidity and low interest rates created an incentive for homeowners to cash out equities built up in their homes through refinancing, commonly referred to as home equity line of credit and loans. The cashed-out equity was largely used to support a consumption boom and masked the stagnating income growth among middle-class households. By emphasizing debt multiplication and relaxing credit standards, financialization has led to rapidly growing corporate debt-to-equity ratios and household debt-to-income ratios; acceleration of dominance of the financial sector relative to the real sector; income transfer from the real sector to the financial sector; deterioration of income distribution and increased income inequality; and changes in the orientation of the economy from saving-investment-production-export orientation to one of borrowing-debt-consumption-import orientation.

The growth of financialization

A number of interrelated factors have promoted financialization in the United States, including financial deregulation, lax supervision and enforcement, implicit government subsidies, and accommodating monetary policies.

Financial deregulation in the form of the Gramm-Leach-Bliley Act (also referred to as the Financial Services Modernization Act) in 1999 opened the floodgates of the “anything goes” mentality in the financial sector. Principally, the Glass-Steagall Act was repealed, enabling commercial banks, investment banks, and insurance companies to form any combination of these activities, hitherto separated by a wall. For example, this allowed commercial banks to take investment banking risk and investment banks to accept deposits. As the financial sector became deregulated, supervision and enforcement, which shoul...

Table of contents

• Cover
• Title
• 1  The Financial SectorIn Support of Growth or Financialization?
• 2  Recurring Financial CrisesThe Causes
• 3  Recurring Financial CrisesThe Fallouts
• 4  Recurring Financial CrisesThe Essential Reforms
• 5  Conclusions and Our Financial Future
• Bibliography
• Index