Hate too-big-to-fail banks? Then you should love CDOs …

A random thought, presented without much serious consideration behind it:

The more we do away with too-big-to-fail banks, the more we need CDOs and the like to provide risk and liquidity transformation.

Suppose we replace one giant, global bank with many hundreds of small banks. Each small bank will end up specialising in specific industries or geographic regions for reasons of localised economies of scale. There exists idiosyncratic risk — individual industries or geographic regions may boom or go belly up. A giant, global bank automatically diversifies away all that idiosyncratic risk and is left with only aggregate (i.e. common-to-all) risk. Individually and in the absence of CDOs and the like, idiosyncratic risk will kill off individual banks. With CDOs and their ilk, individual banks can share their idiosyncratic risk without having to merge into a single behemoth.

In the event of a true aggregate shock, the government will end up needing to bail out the financial industry no matter what the average bank size because of the too many to fail problem.

There are problems with allowing banks to become TBTF.  They end up being able to raise funding at a subsidised rate and their monopoly position allows them to charge borrowers higher rates, both contributing to rent extraction which is both economically inefficient (the financial industry will attract the best and the brightest out of proportion to the economic value they contribute) and fundamentally unfair. Worse, the situation creates incentives for them to take excessive risks in their lending, leading to a greater probability of an aggregate shock actually occurring.

But we are now trying to kill off TBTF in a world in which credit derivatives have either vanished altogether or are greatly impaired. On the one hand, that reduces aggregate risk because we take away the perverse incentives offered to TBTF banks, but on the other hand, it also reduces our ability to tolerate idiosyncratic risk because we take away the last remaining means of diversification.

7 Responses to “Hate too-big-to-fail banks? Then you should love CDOs …”

  • Are you fucking serious? Is this 2007? Spread the risk and we’ll be ok?

    What planet were you on in 2008 when this very magic you speak of NEARLY DESTROYED THE WORLD ECONOMY?

    • Quite serious, yes. Note that CDOs, properly designed, should serve to reduce volatility in the economy as a whole. The suggestion that they are solely responsible for the GFC is specious.

  • The small banks can issue loans requiring more equity from the borrowers, reducing risk and leverage. They can sell some of their loans and buy from other banks to diversify geographically. They can participate in loan syndicates. True: small =/= safe. S&L bust was mostly small banks. Could there be a happy medium? Large enough to have economy of scale, to properly do due diligence, to afford up-to-date IT, to have proper risk monitoring. Small enough to not cause systemic problems from a few rogue traders or loan officers, to have a direct incentive for employees to care about their individual decisions …

    • Requiring more equity from borrowers is something that can be instituted no matter the size of the lender and no matter the facilities available to diversify the risk.

      Allowing local banks to sell some of their loans and to buy some from other banks (and so diversify) is exactly the purpose of ABSs, CDOs, etc., so I think we’re in agreement.

      • Really? I suppose CDOs imply tranching, more leverage, involvement of I.B. middlemen, hiding of risk from unsophisticated participants etc for the allegedly more liquidity (which evaporated in the crisis). Simple loan markets may be less liquid but participants are also knowledgeable. Why would a knowledgeable investor spend all the effort to study up on a borrower if he has no control with a CDO manager sitting between him and his loans?
        At a minimum this hardly justifies “loving the CDOs”.

  • You’re missing the source of the problem. You can’t charge infinite fixed interest in a finite world. Why not get rid of ALL finance risk in the first place, and have a more flexible system with sharing of a percentage of revenues rather than fixed interest. In such a scenario you won’t have companies going bust because they can’t make a loan payment, given their payments would just increase or decrease with their revenues. The banking system needs an upgrade. The current system is intentionally build to be flawed to benefit the super rich, rather than the economy for everyone. It’s the worst form of corporate welfare in history, siphoning money away to where it’s not needed.

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