Risk concentrations and the length of the financial intermediation chain

4​ • 2011

Editorial

Both academics and policymakers have for a long time, and often quite intensely, debated the relative merits and optimality of bank-based vs market-based financial systems. Recent research has argued that classifying financial systems as either bank-based or market-based may not be useful from the perspective of distinguishing financial systems. In fact, the most recent financial crisis provides a perfect example of why thinking in terms of a sharp distinction between bank-based and market-based financial systems does not greatly enhance our understanding of the dynamics of financial systems.
 
More specifically, the current crisis has the distinction of being the first post-securitization crisis in which banking and capital market developments have been closely intertwined.[1] Although in a historical context we are used to thinking of banks as reacting to changes in the external environment, expanding and contracting lending in response to shifting economic conditions, in a market-based financial system built on securitization banking and capital market developments are inseparable.
 
Securitization itself was marketed as an efficient means to allocate risks optimally, but a view has now emerged arguing that in the final crisis the risks seem to have been concentrated in the financial intermediary sector rather than with the final investors, who should have been better able to bear it. Not only do we have to dispense with the old view, so the argument goes, that emphasized the positive contribution of securitization to efficient allocation of risks, but also with the ‘hot potato’[2] hypothesis, in order to understand the role played by securitization in the financial crisis. The ‘hot potato’ hypothesis fails to explain why securitization worked well for thirty years before the subprime crisis and also fails to distinguish between selling a bad loan down the chain and issuing liabilities backed by bad loans. If a bank manages to sell a bad loan, it gets rid of the bad loan and it is then someone else's problem. On the other hand, by issuing liabilities against bad loans, the bank does not get rid of the bad loans. In fact, instead of passing the hot potato to a greater fool next in the chain, a bank may end up keeping the hot potato on its own balance sheet or pass it to a special purpose vehicle that the bank is sponsoring.
 
A distinct feature of financial intermediation based on securitization is the long chains of financial intermediaries involved in channelling funds from the ultimate creditors to the ultimate borrowers. An important observation in this context is that the longer the chain the more heavily it is dependent on the overall developments in the capital markets. More potential break points are introduced into the chain once it grows longer, so the natural question seems to be what are the benefits of such long intermediation chains? The experience from the most recent financial crisis suggests that it cannot be dispersion of credit risk, since the underlying interaction between banking and capital market development appears to have concentrated, not dispersed, such risks. This issue does, however, need further exploration in order to get a clearer picture.
 
An alternative reason could be an inherent need for maturity transformation in the financial system emerging from the demand for short-term claims by ultimate creditors. This maturity transformation can be made easier by coupling lending relationships together in a long chain of intermediation. This, in turn, implies the need to re-think the role of short-term debt. According to the more traditional thinking emphasizing banks' rigid and fragile deposit-only capital structure, short-term debt is a disciplinary device for bank managers not to engage in actions that dissipate the value of the bank's assets or an incentive mechanism for managers not to try to extort rents. However, prior to the most recent financial crisis, the ultra-short nature of financial intermediaries’ obligations to each other cannot be easily explained by retail depositors’ demand for short-term liquid claims.
 
More research is needed to shed light on this issue, but perhaps we can speculate on the idea that the long chain of intermediation fundamentally reflects the changing role of banks in the financial markets. Improvements in information technology and communication have had the effect of making public markets better informed so that eg more firms now have access to direct market funding. But these developments have not driven banks out of corporate lending, since they have refocused their core competence. Banks’ core competence is to provide not funding per se, but funding on demand. In order to maintain its core competence, a bank needs to transform its assets continuously, which may explain and further strengthen the interaction between capital market developments and banking.
 
Jouko Vilmunen
 
 
 [1] This is most convincingly spelled out in an analysis by Hyun Song Shin, Financial Intermediation and the Post-Crisis Financial System, BIS Working Papers No 304. March 2010
[2] "Hot potato" hypothesis is the name Shin (ibid.) gives to the new wisdom that emphasizes the chain of unscrupulous operators who passed on bad loans to the greater fool next in the chain.
 

 Jouko Vilmunen

 
Jouko Vilmunen