Crawl Across the Ocean

Tuesday, April 27, 2010

50. The Trouble With Lending

Note: This post is the fiftieth in a series. Click here for the full listing of the series. The first post in the series has more detail on the book 'Systems of Survival' by Jane Jacobs - it would be helpful to have read that post before reading this one.

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"In her 1994 book, Systems of Survival, Jane Jacobs proposes the theory that there are only two ways in which human beings acquire objects: taking and trading. Everything we do in the way of accumulation falls under one of these two heads, says Jacobs, and we should never confuse the two. ...

When I first read this book, I became obsessed with finding transactions that would not fit into this double-headed scheme. At first I thought of gifts: surely a gift is neither taken nor traded. But no: gifts fit under 'trading,' because although no set price is attached to a gift and it is bad form as well as bad luck to sell one, a rule of exchange is still at work. ...

But what about borrowing and lending? Borrowing and lending would seem to exist in a shadowland - neither 'taking' nor 'trading' - changing their natures depending on the final outcome.They're like those riddles in fairy tales: Come to me neither naked nor clothed, neither on the road nor off it, neither walking nor riding. A borrowed object or sum is neither taken nor is it traded. It exists in a shadowland between the two: if the interest exacted for a loan is of loan-shark magnitude, the transaction verges on theft from the debtor; if the object or sum is never returned, it also verges on theft, this time from the creditor. Thus it's 'taking,' not 'trading.' But if the object is borrowed and then returned with a reasonable amount of interest, it's clearly trading. Hostage-taking is the same kind of shadowland transaction: part theft or taking, part trade."
Margaret Atwood, 'Payback'

A little over a year ago, in response to some nonsense about the U.S. Community Reinvestment Act in this post by Andrew Coyne, I started writing a post on the tricky business of lending, but it led me down a few alleys that made me realize I didn't have the theoretical background to really understand what I was talking about, which in turn led me to create my series of posts on ethics, which has basically been me trying to get the necessary background and posting the results as I go along. This post is a little different in that it has an actual argument, as opposed to simply relating concepts or other people's arguments.

* * *

In our discussion of Jane Jacobs' 'Systems of Survival', we've seen that the commercial syndrome operates on a two pronged approach of 1) ensuring that all transactions are win-win (which usually just means that they are honest and voluntary), and then 2) make as many transactions as possible.

Meanwhile, although the exploration of the guardian syndrome is ongoing, we've seen that it operates primarily on a basis of a monopoly which limits the number of transactions rather than maximizing it.

The argument I'm making in this post is that lending is a hybrid of the two approaches in that it is a commercial activity based on win-win trade that relies on the commercial ethics that ensure transactions are win-win in nature, but, due to peculiarities specific to the lending market, the usual commercial approach of maximizing the number of transactions is often counter-productive.

This means that the ethics of lending requires taking the portion of the commercial syndrome attributed to win-win transactions and combining it with the portion of the guardian syndrome linked with controlling rather than maximizing the number of transactions.

If you hear that a burger chain had a rapid expansion in its rate of selling burgers, that would be considered almost unequivocally a good thing (for the burger chain), and if you heard that Microsoft, was selling many more copies of Windows than before then you would figure that is almost purely a good thing (for Microsoft), but if you heard that a bank had made a rapid increase in its volume of loans outstanding, that would generally be considered a red flag rather than a cause for celebration - and with good reason! Probably the most rapidly growing lender in the last few decades has been Citibank/corp/group, an organization which has been bailed out by the U.S. government so frequently that it has become a byword for insolvent lending, and the poster-child for concerns about banks that are 'too big to fail' despite trying repeatedly.

Similarly, U.S. lender Washington Mutual was one of the fastest growing companies in the U.S. prior to it collapsing in the recent financial crisis, prompting former CEO James Vanasek to testify to a Senate subcommittee that:
"[Washington Mutual] was a reflection of the mortgage industry characterized by very rapid growth, rapidly expanding product lines and deteriorating credit underwriting.' and that, 'This was a hyper-competitive environment in which mistakes were made…"
(emphasis added).

So, the obvious question, and the one I've struggled with most in writing this post, is what it is about lending that makes it different from other lines of commercial activity.

As I see it, there are two fundamental problems with lending, both related to gaps in time. The first gap is the lag time between when money is lent and when it is repaid. This time lag creates uncertainty with respect to repayment. This uncertainty is aggravated by the asymmetric information in which the borrower knows more about his ability/willingness to repay the loan than the lender does. It is also aggravated by the fact that borrowers are prone to hyperbolic discounting which causes them to overweight the present (where they receive the borrowed funds) and downplay the future (when they will need to repay the borrowed money) – this leads them to borrower's remorse where they end up with debts they have trouble paying back.

Furthermore, unlike in the insurance industry (which faces a similar problem with information asymmetry and a time lag between the two sides of the transaction), a lender can't easily mitigate this transaction level uncertainty by simply making a large number of loans because of the level of correlation between loans (when one person fails to make repayment, it is more likely that another will fail as well – for example, mortgage defaults in the U.S. over the last few years) which means that there is far less benefit (in diversifying risk) to scale than there would be if each transaction was independent.

We've seen previously that in the face of asymmetric information that favours the buyer, sellers need to exercise restraint. A further temptation is that, since loans usually don't default immediately after the money is lent, a (rapidly) growing loan portfolio will look better on most performance measurements vs. one that is in a steady state or one that is declining in size. Given these factors, a healthy banking industry typically will exist in a state where banks are rejecting a significant number of loan applications, and even more people who would like to borrow don't even apply because they know they will be turned down. Lenders could lend to these people, but they exercise restraint, and reject the short-term approach of maximizing transaction volumes for short term profits.

This restraint creates an opportunity for a sufficiently short-sighted company (or one planning to grow quickly and then bail/sell-out before the market turns) to enter the market and rapidly grow its market share by offering credit to those who are normally turned down, or by offering interest rates below (for loans) or above ( for deposits) what is sustainable over the long term to lure current borrowers away from existing banks. (e.g. see the behaviour of Washington Mutual in the last boom).

The second gap in time is the gap between the expansion of unsustainable lending practices and their eventual collapse. This gap sounds, at first glance, the same as the first one, but it is in fact longer. The first gap existed primarily at a transactional level, whereas this second gap exists at a systemic level. John Michael Greer had an excellent post a few weeks back in which he contrasted the negative feedback of a normal market economy with the positive feedback of the financial economy.

"In a market economy, all secondary goods are subject to negative feedback. That's the secret of Adam Smith's invisible hand: since the supply of any secondary good is limited by the available natural inputs, labor pool, and capital stock, increased demand pushes up the price of the good, forcing some potential buyers out of the market, while decreased demand causes the good to become less expensive and allows more buyers back into the market. Equally, rising prices for a good encourage manufacturers to allocate more resources, labor, and capital plant to producing that good, helping to meet additional demand, while falling prices make other uses of resources, labor and capital plant more lucrative and curb supply."


"It’s when we get to the tertiary economy of financial goods that things change, because the feedback loops governing tertiary goods are not negative but positive.

The late and loudly lamented housing bubble is a case in point. It's a remarkable case, not least because houses – which are usually part of the secondary economy, being tangible goods created by human labor – were briefly and disastrously converted into tertiary goods, whose value consisted primarily in the implied promise that they could be cashed in for more than their sales price at some future time. (As a tertiary good, their physical structure had no more to do with their value than does the paper used to print a bond.) When the price of a secondary good goes up, demand decreases, but this is not what happened in the housing bubble; instead, the demand increased, since the rising price made further appreciation appear more likely, and the mis-, mal- and nonfeasance of banks and mortgage companies willing to make six- and seven-figure loans to anyone with a pulse removed all limits from the supply.

The limits, rather, were on the demand side, where they always are in a speculative bubble: eventually the supply of buyers runs out because everyone who is willing to plunge into the bubble has already done so. Once this happened, prices began to sink, and once again positive feedback came into play. Since the sole value of these homes to most purchasers consisted, again, of the implied promise that they could be cashed in someday for more than their sales price, each decline in price convinced more people that this would not happen, and drove waves of selling that forced the price down further. This process typically bottoms out around the time that prices are as far below the median as they were above it at the peak, and for a similar reason: as a demand-limited process, a speculative bubble peaks when everyone willing to buy has bought, and bottoms when everyone capable of selling has sold."

This is the essence of a bubble, when the normal negative feedback of 'higher price = less demand' gets replaced with the positive feedback of 'higher price = higher demand.'

The cyclical pattern of lending activity can also be seen playing out in the simulations of a credit based economy run by Australian economist Steve Keen.

The cycle is further aggravated in the case of collateralized lending (e.g. mortgage lending, where the property is collateral for the loan) for reasons well explained in an academic paper, 'The Leverage Cycle' by John Geanakoplos (via Rajiv Sethi)

Economists will recognize that this pattern was also predicted by Hyman Minsky's 'Financial Instability Hypothesis'. Minsky's hypothesis was (basically) that what was initially an economic boom based on economic growth would lead to overconfidence on the part of lenders. This overconfidence would lead lenders to expand lending in a fashion that was only profitable during the boom but would lead to ruin when the boom inevitably ended.

Here's a quote from HSBC Chairman, Stephen Green:

"Second, we also need to restore good value to the corporate agenda. The catalogue of errors that we have seen recently in many banks is long.

If there is a common underlying theme, it is a greedy focus on the short-term. A culture had begun to pervade some quarters that it was fine to pursue short-term returns without any concern for the longer-term consequences.

It has never been the responsibility of companies to focus on the short term. There is no question that investors and traders have often put pressure on boards and managements to pursue short-term strategies and profits.

The results of that pressure are now plain to see in the broken businesses and weakened economies around the world. This was the basic failure of corporate governance, at the very least.

We must reject that short term approach to value maximization, and get back to the real task of sustainable value maximization. To put it another way, unless we think more widely about our responsibilities, we will risk losing sight of the very raison d'etre of business: to provide services on a sustainably profitable basis to our customers."

Green recognizes the nature of the problem: a failure to adhere to an ethical requirement to think through the full long-term effects of the bank's actions. But is there any reason to believe that Green or anyone else is likely to resist the pressures of short term focus during the next credit boom? Or that if Green himself does, that he won't be removed from his position as the bank loses market share to aggressive competitors? Ethical action is impossible when not supported by the right environment.

Let's consider two possible outcomes of lending across the economic cycle – one example from either end of a spectrum: At one endpoint, banks remain cautious through the good times, there are limited new entries to the industry and the existing lenders do not compete with each other to gain market share in the segment of unprofitable (over the full cycle) borrowers or undercut each other's rates on existing customers – either because the lenders exhibit collusive behaviour amongst themselves, or because government legislation prevents them from competing against one another.

Lending standards remain strong and when the eventual downturn comes, the lenders face increased losses but this is offset by profits from the good years and there are no serious problems (actually, in the extreme case, it might be possible to eliminate the business cycle altogether, but this would likely require changes to our myopic human nature in general – not just on the part of lenders).

At the other endpoint, during the good times, there are new entrants to the financial market that offer credit to those who will be unprofitable during the good times and who undercut interest rates on existing customers. Forced into a competition (or maybe they start it themselves) the existing banks respond. The financial marketplace grows, there is 'innovation' with respect to lending to riskier customers, collecting less information from borrowers, offering unsustainably low interest rates on loans and unsustainably high interest rates on deposits, extending amortization periods to pull in new borrowers, and so on. When the downturn comes, it is more severe because the boom was inflated by the easy credit in the positive feedback cycle we discussed earlier. The organizations that grew the fastest during the boom become the ones that fail the fastest in the downturn. Those organizations derided as staid and hidebound during the boom become pillars of strength lauded for their prudence and discretion. Does any of this sound familiar?

So, to summarize, the two gaps in time combine to create an environment where lenders can temporarily prosper by lending in an unsustainable fashion. Individual market players (e.g. CEO's of innovative lenders) might be able to make enough money to retire before the music stops. More importantly, those banks that resist the siren song of unsustainable lending will find themselves losing market share to their competition. Newspapers will write stories comparing how the aggressive Royal Bank of Scotland is leaving staid Royal Bank of Canada behind, and the longer the boom lasts, the more the pressure to jump into the risk pool will grow and grow.

From the financial times article I linked just above, there's also an interesting quote on the importance of regulation in the cycle,
"We are extremely non-capital-intensive,' TD's Ed Clark told me. 'That is because of the regulatory regime. If we were an American bank I couldn’t do it. I would be forced up the yield curve."

A final, further aggravating factor is the inherently unstable nature of banking. At any given moment, a bank has millions or billions of dollars in deposits that customers can access at any time, but because banking operates in the same manner as a Ponzi scheme, the bank never actually has any but an exceedingly small fraction of deposits on hand at any given moment. This means that a bank can be more vulnerable to a reversal of fortune than you might otherwise expect. The Diamond-Dybvig model shows how a loss of confidence can cause an otherwise sound bank to become insolvent after a run on the bank collapses the Ponzi scheme. Governments have largely offset this risk through deposit insurance but in the most recent crisis, a significant share of deposits in the United States had been siphoned off into an unregulated 'shadow banking' sector, which promptly collapsed when the financial crisis hit.

* * *

So let's bring this back into 'Systems of Survival' terms.

We've seen that the commercial syndrome consists of two main thrusts:
1) Make sure that transactions are win-win
2) Make as many transactions as possible

Point number #1 is no different in its importance in banking then it is in other businesses, and is in fact arguably more important in banking because the gap in time before repayment makes it less certain up-front whether a transaction is truly win-win or not. Point #2 however, is where lending differs from the standard business model. Because of the combination of a cyclical pattern of activity and asymmetrical information, successful lending through the economic cycle requires restraint from market participants during the up side of the cycle, restraint meaning that they optimize rather than maximize the number of transactions (loans) they make.

So let's compare the commercial syndrome and guardian syndrome ethics that relate to maximization (or not) of the number of transactions:

Be industrious, efficient vs. Make rich use of leisure.

Chances are you've never heard of an auto plant holiday, or a grocery store holiday or an IT holiday – but you have heard of a bank holiday.

'Prior to 1834, the Bank of England observed about thirty-three saints' days and religious festivals as holidays, but in 1834, this was reduced to just four: 1 May, 1 November, Good Friday, and Christmas Day. In 1871, the first legislation relating to bank holidays was passed when Liberal Politician and Banker, Sir John Lubbock introduced the Bank Holidays Act 1871 which specified the days in the table set out below.[1] Sir John was an enthusiastic supporter of cricket and was firmly of the belief that bank employees should have the opportunity to participate in and attend matches when they were scheduled. Included in the dates of bank holidays are therefore dates when cricket games were traditionally played between the villages in the region where Sir John was raised'

OK, maybe that's just a historical accident, but then consider the definition of "Banker's Hours" - a short working day.

Need more (anecdotal) evidence? How about the U.S. savings and loans industry which (before it collapsed in crisis) was known to follow a 3-6-3 model. 3-6-3 stood for borrow at 3%, lend at 6% and hit the golf course by 3pm.

Now in most industries, you'd tell a story of how this lazy behaviour was broken down by competition, companies got aggressive, prices dropped for consumers and all was well. But of course, in banking the story is that this lazy behaviour was broken down by competition, companies got aggressive, prices dropped for consumers and then there was a massive crisis leading to a slew of arrests, multi-billion dollar government bailouts and calls for reform.

To sum up - the historical evidence suggests a clear line of demarcation between banking and other commercial ventures on the topic of making use of leisure vs. being industrious and efficient.

OK, next precepts, from the commercial syndrome, 'Be innovative' and 'Use initiative and enterprise' vs. from the guardian syndrome, 'Respect for tradition'

OK, we focused on the second 3 in the 3-6-3 formulation when talking about leisure, but the 3-6 part is important too as it represented a traditional, not innovative method of pricing for the savings and loans.

Here's a thought experiment. Imagine you are CEO of a company, and the department heads are giving you updates at a senior management meeting. The head of engineering tells you that they were having trouble getting the product weight below a certain threshold but they found an innovative solution. Sounds good, right? Next up, the chief accountant tells you that they were having trouble getting the balance sheet to meet your debt covenants but they found an innovative solution? Sounds good? - maybe if you're the CEO of Enron...

On the topic of the financial industry, there's been a running debate in the blogosphere over the last few months over the question of whether financial innovation exists and if so, is it good or bad. Even legendary former Fed chairman Paul Volcker weighed in, suggesting that the only useful financial innovation of the last generation was the ATM.

To me, what is telling is that the debate even exists.

The question comes back to constraints. Innovation is good when it is overcoming natural barriers, but when it is overcoming barriers put in place by government for a reason, it's generally not so useful.

Compared to say, aviation, the number of natural constraints faced by lending is quite small:
1) Uncertainty about repayment likelihood due to asymmetrical information
2) Uncertainty about repayment due to irreducible uncertainty about the future course of events
3) Capacity of borrowers, availability of profitable investments to borrowers
4) Willingness of capable borrowers to borrow

Historically there was some room for overcoming the natural problems of time and space (e.g. via ATM's and cheques, etc.) but there was never a ton of scope for innovation there and these days infinite volumes of money can travel at effectively infinite rates of speed to almost any location on earth so I'd say the financial industry is pretty much done innovating on that front.

The primary area where there is scope for beneficial innovation in lending relates to point 1 (overcoming the lack of information), with credit bureaus, credit scoring, and the lending circles of micro-credit being examples of this sort of information enhancing innovation at work (a good sign that innovation in the lending industry has run amuck is when the innovation is to get less information from borrowers). But even here, there is quite limited scope as compared to other industries.

There's not much you can do about point 2 above (and if there was, there would be more profitably ways to use it then reducing your loan loss rate!) And to the extent that innovation targets points 3 and 4 above, history suggests that what looks like innovation is simply errors that will take some time to be revealed.

So to summarize, innovation has a poor record in the lending industry (remember the WaMu chief's comment about rapidly expanding product lines, above), and the attitude towards innovation is very different than it is in other industries.

On the topic of tradition, it's no secret that bankers have long been renowned for being conservative in nature, with 'stodgy' being a typical choice of adjective.

There was a bestselling book on the Canadian Banking Industry written in the 1980's by Walter Stewart. It was titled, "Towers of Gold, Feet of Clay" a nice literary rendering of the guardian precepts 'Respect Tradition' and 'Be Ostentatious'. Naturally, the book was highly critical of the Canadian banks for their heavy footed traditional ways, much as the media was during the recent credit boom, but the banks are still around, more respected than ever (albeit not by customers!), while the book is long forgotten.

The book is forgotten, but it's not like Stewart was wrong about either the traditional nature of banking in Canada (as compared to most other industries) and the level of ostentation. Condo projects in Vancouver that replace a historic building with architectural significance are often required to preserve the façade of the old building. In many cases, the ornately carved and impressive façade that is retained is one from an old bank branch. Even the Canadian Hockey Hall of Fame is located in a former bank branch!

Here's an article from the 'Canadian Encyclopedia' on Bank architecture (do you suppose they have an article on grocery store architecture – I doubt it!) The article suggests that,
'[the banks] adopted chiefly classical architectural forms which expressed wealth, integrity, endurance and confidence.'
...but they seem to take it for granted that bank's will make bolder architectural statements than other businesses without ever wondering why.

Travelling the interwebs, I see people often assume that the reason banks had such beautiful branches was to impress customers of how safe and solid and wealthy the bank was. That may have been part of it, and the encyclopedia article does suggest a move from 'image to efficiency' in the postwar years (somewhat in sync with the imposition of deposit insurance which would lessen the need to project his image), but as the encyclopedia article itself notes, what seems to have happened is that the banks simply changed their focus of ostentation from the branches themselves to the head office buildings (e.g. the towers of gold in Walter Stewart's title), with our downtown cores now occupied largely by financial towers with impressive atriums and artwork, giant swinging pendulums, abnormally large walls of plants and so on.

My suspicion is that this bank ostentation simply reflects the bank knowing that there is no need to invest the money spent on the buildings in expanding the business because expanding the business too much would lead to the problems of an overly competitive banking industry. Probably every business would like to build impressive architectural monuments to their own magnificence, but other businesses know that if they spend their money in such unproductive fashion, they will lose ground to competitors who are spending that money on research and development or cutting prices instead.

OK, next precepts: From the commercial syndrome, Collaborate easily with strangers and aliens vs. from the guardian side, 'Be exclusive.' This is traditionally an area of some controversy in banking. In 'The Life and Death of Great American Cities' Jane Jacobs complained that banks wouldn't lend in certain neighbourhoods.

Responding to concerns like the ones Jacobs expressed, in 1974, the United States passed the 'Equal Credit Opportunity Act' prohibiting discrimination in lending on a whole host of criteria. This was followed up by the 'Community Reinvestment Act' in 1977 which basically added discrimination by neighbourhood to the list of banned reasons for discriminating.

Why did the lending industry in particular need anti-discrimination legislation - can you imagine the U.S. government passing legislation prohibiting discrimination by video rental shops or home improvement stores? No, me neither. Admittedly, the insurance industry sometimes faces similar issues, so part of the issue is simply asymmetrical information at work, but the regulations on 'discrimination' in banking generally go beyond anything ever imposed on the insurance industry.

The U.S. is a country with a strong commitment to the commercial syndrome so it struggles with the banking industry which does not fall entirely in line with the commercial syndrome. It is in the nature of banking to be exclusive, in that a bank must ensure that it only deals with trustworthy customers or else it will quickly go out of business. Few transactions require more trust than giving somebody money on a promise that they will pay it back later. Given perfect information, a bank could simply lend to those that will repay it, and turn down those who won't. In the absence of this perfect information, banks are required to develop rules to separate people into the turndown pile. Where banks get into trouble is with generalizing across whole neighbourhoods or groups of people that those people are in general a bad credit risk, as this approach conflicts with our modern, commercial syndrome based, individualistic ethos in which each person is believed to have the right to be treated based on solely on their individual (behavioural) characteristics and not on the characteristics of any group that they belong to by the nature of their birth or place of residence or any other factor which is largely outside their control.

Canada has not been immune to these sorts of concerns either, with small business complaints about stingy lenders being a routine feature of the Canadian political landscape, although the Canadian approach has generally been for government to step in and replace the bank as lender (either directly or via guarantees) as for example with student loan programs, with the creation of the Canadian Mortgage and Housing Corporation (CMHC) or with the Small Business Financing Act of 1998.

Historically, cartoons involving banking generally made fun of the difficult lengths someone must go through to get a loan. In more recent years, leading up the financial industry collapse in the U.S., cartoons switched over to making fun of how anyone with a pulse could get a loan. The first situation led to bankers being unpopular, the second approach led to a global financial crisis, bankers becoming even more unpopular and a reversion to the old style of comics and lending behaviour.

The attitude of the lending industry towards exclusiveness is so different from the rest of the commercial industry that while 'cosmopolitan' came to mean accepting and openness to all types of people, governments were passing laws to force lenders to lend to types of people that they chose not to. Once lenders turned around and started lending to all sorts of people (in the manner that a normal business will sell its products to anyone who can pay for it) we had a financial crisis and lenders were condemned (rightly) for luring people into loans they had no chance of repaying.

This is all very different to how things operate at say, Wal-Mart or Safeway.

OK, finally, let's look at the big precept underlying the whole issue, from the commercial syndrome, 'Compete' and from the Guardian syndrome, 'Cooperate' (Note: Jane Jacobs didn't include cooperate on the guardian side but she listed it as a universally praised attribute, and as I explained back here, I think it is contradicted by 'Compete' on the commercial side and hence a guardian virtue.)

Competition is the lynchpin of the whole suite of commercial ethics devoted to maximizing rather than optimizing the volume of transactions, so it follows that the most effective way to neutralize the damaging effect (on the lending industry) of this portion of the commercial syndrome is to limit competition.

Consider the Canadian banking system. The marketplace is dominated by a handful of large institutions and pretty much always has been. With respect to pricing there is a perception that there is little differential between the prices charged at the different banks and not a lot of effective competition between the banks. Which is not to say that there is no competition between the banks (there's more than there is in the cable/phone markets!), but historically it has only gone so far and has been limited, even in comparison to other industries with a similar number of market players.

As a result, over the years, the Canadian government, motivated by the prevailing commercial syndrome mindset that competition=goodness, has repeatedly undertaken studies of the level of competition in the banking sector, repeatedly concluding that the market is largely an oligopoly, with limited competition, and that the government should encourage more competition in the lending market. For example, see here, or here)

Here are some comments from Gilles Menard of the Canadian competition bureau, from back in 1996 (note that he was speaking specifically on the financial sector), which concisely capture the prevailing wisdom regarding competition:

"Competition policy is founded on the recognition that competitive market forces should act as the fundamental driving force in our economy.

Regulation which restricts competitive market forces should be the exception, NOT the norm. Why is that?

First, competition is much better than regulation in creating incentives for innovation. It is better at fostering new products, new services, new methods of doing business.
Second, competitive markets drive the prices of goods and services towards their costs of production.

Competition is better than regulation at prompting businesses to cut the costs of bringing products and services to clients. This is particularly true where rapid technological innovations ---such as the information revolution--- are sweeping through various industries.

Third, this effort to lower the costs and to respond to customers needs minimizes the misallocation of resources in the economy. It enhances economic efficiency, thus generating benefits for the entire economy."
(emphasis added).

The questions of course are do we want more innovation in lending, and do we want prices cut to the margin in a procyclical pattern and most importantly, does competition in lending reduce or increase the misallocation of resources in the economy?

OK, you say, why should I care what Gilles Menard thinks? And anyway, that was back in 1996 before we had a global financial crisis in which the damage done seemed to be proportional to the extent that, driven by powerful competitive forces, the lending industry engaged in unsustainable innovation that caused it to grow rapidly before collapsing again.

If that's what you're thinking, then consider this quote. It was made only a month ago, so it's timely, and it comes from Ben Bernanke, perhaps the most powerful banker in the world, the man (most) in charge of steering the global economy through the recent crisis, and a man appointed to his position in the first place because of his extensive academic knowledge of financial crises:

...Toward a More Competitive, Efficient, and Innovative Financial System

The United States has a financial system that is remarkably multifaceted and diverse. Some countries rely heavily on a few large banks to provide credit and financial services; our system, in contrast, includes financial institutions of all sizes, with a wide range of charters and missions. We also rely more than any other country on an array of specialized financial markets to allocate credit and help diversify risks. Our system is complex, but I think that for the most part its variety is an important strength. We have many, many ways to connect borrowers and savers in the United States, and directing saving to the most productive channels is an essential prerequisite to a successful economy.

That said, for the financial system to do its job well, it must be an impartial and efficient arbiter of credit flows. In a market economy, that result is best achieved through open competition on a level playing field, a framework that provides choices to consumers and borrowers and gives the most innovative and efficient firms the chance to succeed and grow. Unfortunately, our financial system today falls substantially short of that competitive ideal.

...if a firm is publicly perceived as too big, or interconnected, or systemically critical for the authorities to permit its failure, its creditors and counterparties have less incentive to evaluate the quality of the firm's business model, its management, and its risk-taking behavior. As a result, such firms face limited market discipline, allowing them to obtain funding on better terms than the quality or riskiness of their business would merit and giving them incentives to take on excessive risks.

Having institutions that are too big to fail also creates competitive inequities that may prevent our most productive and innovative firms from prospering. In an environment of fair competition, smaller firms should have a chance to outperform larger companies. By the same token, firms that do not make the grade should exit, freeing up resources for other uses. Our economy is not static, and our banking system should not be static either.

In short, to have a competitive, vital, and innovative financial system in which market discipline encourages efficiency and controls risk, including risks to the system as a whole, we have to end the too-big-to-fail problem once and for all."
(emphasis added, except for the title)

This is a really remarkable quote. Bernanke's commercial syndrome mindset is all-encompassing. He's a very smart man and he intuitively understands Jane Jacobs idea that the syndrome falls apart if it is breached. In the speech (you should really read the whole thing - as always!) he has latched on to the notion that some firms have an implicit government guarantee as the critical guardian breach in the commercial syndrome and he follows that logic to its conclusion.

Yet somehow, the fact that he lives next door to a country in which every major financial institution has been too big to fail since the country was founded, and that country has an enviable record of avoiding financial crises just doesn't penetrate into his thinking as the obvious counter-example that completely invalidates his whole line of reasoning.

In the year or so that I've been sitting on this post, I've been keeping an eye out for posts in the blogosphere that touch on this topic. It's been interesting seeing very bright people try to get heir heads around the idea that what they believe to be true about markets in general doesn't seem to really apply in the lending industry. The first, and still the clearest proponent of the less competition is better for lending argument has been John Hempton on his blog, 'Bronte Capital':

"I have spent a bit of time looking at how banks collapse in countries other than the US. The model I have in head is Taiwan. Taiwan until relatively recently had about 50 banks. This is in an economy about the size of a mid-ranking US State.

The banks were highly competitive and margins were sickly thin. Bank management respond to the high margins by increasing risk. Its kind of odd but banks in highly non-competitive markets (eg Australia) have returns on equity of about 18 percent. Banks in highly competitive markets seem to have equity returns of about 16 percent. The difference is that in highly competitive markets the banks take more risk to get 16% and they tend to blow up with monotonous regularity. A blow-up in Taiwan causing something looking like a local recession happens more than once a decade.

Every blow up results in the reduction of the number of banks. As this happens the level of competition goes down and the profitability goes up. At the end you wind up with a banking system like Australia – which has four super-profitable banks. These four banks can survive almost anything because the pre-tax, pre-provision operating profit is so huge. In Australia and New Zealand the numbers are almost 5 percent of GDP.

I know what I am doing is turning standard economic dogma (particularly amongst conservatives) on its head here. The standard dogma (questioned by some with financial services) is that competition is almost everywhere a good thing. But I would have the other view. My view is that competition in financial services causes massive financial crises.


What I am advocating is – that as a matter of policy – you should deliberately give up competition in financial services – and that you should do this by hide-bound regulation and by deliberately inducing financial service firms to merge to create stronger, larger and (most importantly) more anti-competitive entities."

It may not be coincidence that John once worked in the Australian banking industry which, like the Canadian banking industry that I have worked in off and on over the years, has been largely composed of a few large banks for many years.

In a second post on the topic, John notes that Hong Kong has one of the coziest oligopolistic banking industries in the world, and, obviously, this has done anything but prevent Hong Kong from achieving economic growth (although, to be fair, Taiwan's economy has survived repeated financial crises fairly well also).

Here's something to consider from Mike Konczal. Mike is confused as to why if competition increased in the lending industry, profits increased as well. Of course in the negative feedback world of Adam Smith described by John Michael Greer above, more competition means less profits. But in the positive feedback world of the lending cycle, more competition generally means more profits - followed by a crash. All the ethics (related to maximization of transactions) that you expect to work a certain way in the commercial syndrome, ending up working in the opposite way in the lending industry.

The trigger for me to finally finish this post off and put it up on the blog was seeing Paul Krugman, after a year of looking at the problem from different angles, end up coming to a similar conclusion regarding the effects of competition in lending. Krugman concludes:

"So I’d suggest that what we [in the U.S.] did between 1980 and 2008 was to replace a financial system in which profits were created by lack of competition with a system in which profits were created by misinformation and misperceptions — a giant, if mostly (not entirely) unintentional Ponzi scheme, which finally went bust.

And without strong reform, it will happen again."

In any economic dispute, it's always reassuring to have Krugman on your side, because more often than not, he ends up being right.

Finally, I know it’s not very blogmanlike behaviour to take note of actual research on a topic, but I should note that in the theoretical literature, there is an ongoing debate on the beneficial/harmful nature of competition in the lending market. Much like the case with innovation, just the fact that a debate exists at all should give us pause.

The standard academic reason why less competition would benefit the banking industry is that less competition makes banks more profitable which raises the potential costs of going bankrupt which makes banks more cautious which leads to more stability ('franchise value theory'). To be honest, although I agree with the conclusion, I am a bit skeptical of the reasoning which seems a bit like an attempt to fit a pattern of behaviour into the strait-jacket of rational self-interest even though rational self-interest is not really the relevant force at work here.

My experience has been that companies are generally driven to compete out of fear of being left behind in the marketplace. If banks feel that they can maintain a conservative posture with respect to lending without losing too much market share, they will. The lack of competition has its effect, not as much by raising bank profitability (although certainly that has a role), but simply by preventing the harmful intrusion of market-share stealing competitors who will force everyone to respond to their efforts in a prisoner's dilemma style race to the bottom. Lenders want to do the right thing, and will, unless competition forces their hand. But that's mostly a matter of semantics, perhaps. Anyway, here's a paper from the World Bank that seems to provide a decent, unbiased survey of the research out there on the topic.

Summarizing, at the very least, the notion that competition is good is more controversial in the lending industry than it is in most other industries.

* * *

Even if, for the sake of argument, we assume that policymakers accept the theoretical case for less competition in the lending industry, the notion of simply allowing lenders to have an industry which is protected from competition and which generates large oligopoly profits is distasteful to many (John Hempton titled one of his posts, "The Case for Letting Bankers Rip Us Off'). So recent years have seen efforts to implement an alternative approach, led by the Bank for International Settlements (sometimes known as 'The World's Central Bank'): instead of limiting competition in order to limit risky lending, use global capital requirements which take into account the full through the cycle risks to prevent banks from getting a (temporary, yet still telling) competitive edge through unsustainably risky lending and to ensure they have enough capital to survive any likely downturn (the requirements are set to, in theory, provide enough capital to cover a 1 in 1000 year event).

The underlying logic of the Basel 2 Capital Accord (a global agreement to define the required level of bank capital), was that every loan would be priced based on a model that reflected the full through the cycle risk that the lender was taking on by making that loan, reflecting the risk of the borrower, the nature of the product, the history of economic cycles and so on. By fully pricing in the risk through the full cycle, this would mitigate the problem whereby those lenders willing to take on unsustainable lending practices gain an advantage over their rivals, leading the industry down into a vicious circle of 'hyper-competitive lowering of standards' as described above by the CEO of Washington Mutual. Basically, the idea (hope?) is that mathematical analysis can overcome the information asymmetry problem I described earlier.

Basel 2 hadn't really been implemented at the time of the last financial crisis so it's probably too early to tell if it (or a revamped Basel 3) will work in future, but even if there is full compliance with the rules across all countries, Nassim Taleb's, the Black Swan offers some arguments why the rules likely won't work anyways. I guess time will tell.

Another possible approach would be to just have lots of small banks, banks so small that if they fail, it's no big deal, the government will just step in and wind them up in an orderly fashion. Knowing that they could fail, 'market discipline' would keep banks in line and keep customers away from banks that get out of line (except with respect to deposits, I can't see us taking away deposit insurance and once again allowing Matthew Cuthbert to die of a heart attack because his bank failed.)

You can see a yearning for this sort of model in the commentary of many Americans on this issue. The problem with this approach is that, as John Hempton notes, the U.S. had thousands of small banks during the depression, and a lot of them failed, just as you'd expect, and this didn't really turn out to be a good outcome. If the failure of each individual bank was an independent event (such that one failing didn't make another one failing more likely), then this approach might work, but that's not the way it is.

Furthermore, this approach foregoes economies of scale in the lending industry (although there don't seem to be too many economies of scale in lending)

The advantage of this approach is that it might limit the political power of financial institutions. When Steve Randy Waldman responded to John Hempton's ideas about competition, one of his counter arguments was that politics trumps economics when it comes to big banks (although Steve seemed to misread John's post, thinking that John's main point was better regulation, when his main point was less competition.)

Summarizing: so far we don't have any proven alternatives to the non-competitive bank model.

* * *

The example of the Canadian mortgage market provides an example of the relentless logic of Minsky's financial instability hypothesis and the lending cycle at work.

It may seem hard to believe in this, 'You're richer than you think' world, but many years ago it was quite difficult to get someone to lend you the money to buy a house without a down payment that made up a major percentage (e.g. > 25%) of the property value. So much so that the government created a crown corporation, 'The Canadian Mortgage and Housing Corporation' whose mandate was to make this lending more plentiful. CMHC does this by guaranteeing mortgage loans, provided they meet certain criteria. With the backing of the federal government, and the diversification and scale provided by a national operation, CMHC is able, in theory at least, to profitably extend the range of lending that banks are willing to offer for mortgages.

But over the years that CMHC has been in existence, there has been a general trend towards loosening of the mortgage rules. As far as I know, despite the efforts of the BIS, there is no theory that will tell us what kind of rules works best, but practical experience suggests a rule requiring a certain maximum 'loan-to-value' before making a loan. In other words, require a down payment so that you are lending less than the full value of the property. Requiring a significant down payment on an asset purchase ensures that a) The borrower had the wherewithal to accumulate a bit of money in the first place, b) That the borrower 'has some skin in the game' and will be motivated to repay lest they lose their down payment, even if the asset declines in value somewhat and c) that the lender is also at risk if there judgment is so poor that the loan is not repaid and the value of the asset falls so much that there are losses that can't be covered with the down payment.

So when Canada elected a Conservative government in 2004, a government which is so invested in the 'competition=good' notion that they have been feverishly working to ensure that Canadian wheat farmers compete with each other to offer low prices on Canadian wheat to foreign buyers, it wasn't long before the government was also working to increase competition in the mortgage insurance industry (which had consisted of CMHC plus one private company for the last few decades) based on the notion that lending was just like any other industry where competition was always and everywhere a benefit.

Soon, banks were allowed to offer mortgage without insurance up to 80% loan to value (rather than the previous 75%), the insurers increased the length of amortization they were willing to offer from 25 years to 30 years to 35 years and finally to 40 years, and the maximum loan to value for insured mortgages was raised from 90% to 95% to 100%.

The Globe and Mail article I linked to above notes that in response to Conservative measures to open up the market for insured mortgages,
"The foreigners unleashed what one U.S. insurance executive described as a fierce 'dogfight for market share' that prompted rivals, including the giant federal agency Canada Mortgage and Housing Corporation, to aggressively push such risky U.S.-style lending."

It's the same old story.

Somewhat fortunately for the Canadian lending market, we didn't have to outrun the Minksy financial instability hypothesis bear, we just had to outrun our neighbours to the South. When the U.S. mortgage market, which was much further down the road to competition and lower lending standards than the Canadian one, blew up, leading to a global financial meltdown, the new entrants to the insured mortgage market in Canada quickly left again, and the standards were returned a bit of the way back to where they were before, with maximum loan to value ratios for insured mortgages lowered back to 95%, and the maximum amortization period lowered back to 35 years. Not to say that Canada won't eventually suffer because of the unsustainable lowering of lending standards in the market to provide mortgages for people who can't save up for a down payment, but it won't be as painful as it would have been if Canada was the only country in the world and didn't have other people's mistakes to learn from.

* * *

So, if this post is right, treating lending as a purely commercial activity leads to problems. But this doesn't mean that we should treat it as a guardian activity either.

The same gaps in time that cause trouble with the commercial syndrome cause trouble on the guardian side as well. If you recall, I mentioned that the part of the commercial syndrome that related to transactions being win-win still applied to lending. Most of the time, the requirements of a transaction to be win-win are simply that there be no fraud or force involved. But because lending requires the borrower to repay the loan (with interest), it is possible for a lending transaction to end up as a win-lose (or even a lose-lose) transaction, even where there is no fraud or force involved.

Anyone who has read Charles Dickens, or who works for a company like MoneyMart understands how people can impoverish themselves through borrowing foolishly. Hyperbolic discounting causes people to make borrowing decisions they regret after the fact. In fact, in many ways, from the borrower side consumer lending resembles the illegal drug market (it's no coincidence that the local transit buses often feature ads for addiction treatment right next to ads for credit counseling). On the other side of the same token, if the borrower ends up defaulting, it is the lender who ends up on the losing side of the trade.

Many religions, recognizing the potentially harmful nature of lending, ban the lending of money for interest, much as they ban the consumption of drugs or gambling or other activities where human weakness manifests itself. But lending, when done to support investment for productive purposes can in fact be a great liberator and a great contributor to economic growth, so banning lending is not an optimal solution.

The problem with government is that 'investment for productive purposes' is not a government mindset (see this earlier post, where I make the case at greater length). Government distribution of funds is instead based on the precept of 'dispense largesse'.

Government involvement in lending will again lead to too many loans given out only for different reasons. Instead of making unproductive loans because competition and the credit cycle forces them to make risky loans to keep up with the competition, government will be making unproductive loans for political reasons. In 'Systems of Survival', Jacobs has a chapter on how things go wrong when the two syndromes intermingle. The first example is the third world debt crisis. Jacobs ends up concluding that the cause of the crisis was that loans were made based on government priorities (largesse) rather than based on the likelihood of them being repaid.

Jacobs' third example of inappropriate syndrome mixing was again guardian values infiltrating the 'invest for productive purposes' precept of the commercial syndrome in the lending market. This time, her example was the leveraged buyout craze of the 1980's when the guardian notions of force and taking took precedence over commercial notions of voluntary agreements and trading (they don't call them hostile takeovers for nothing). Enabling the leveraged buyouts, was, of course, the leverage, which was provided by lenders who lost sight of their role in lending for investment not for speculation and raiding.

Aside from the risks to disciplined lending, there are also the concerns about inept management and poor customer service that arise when dealing with a monopoly service provider. Ironically, it may be that the poor customer service provided by oligopolistic (e.g. Canadian banks) helps offset the political risk from a concentrated industry. There are always populist votes to be had by bashing the big Canadian banks, and there's no doubt (in my mind) that this contributes significantly to limiting the influence of the banks in Ottawa.

So running lending strictly along guardian lines leads to loans made for non-productive purposes, unsustainable default rates, and a lender needing a bailout (or a timely execution of the creditors, if you want to go old school).

But running lending strictly along commercial lines leads to a destructive boom-bust cycle as competition drives margins down and risk up during a self-reinforcing credit boom which leads to a 'Minsky moment' where the coyote looks down, realizes he's running on air, and the credit bubble collapses, leaving a deep imprint of its body on the landscape of the real economy below.

The solution, as I see it, is to run lending as a hybrid of the two syndromes, taking the elements of the commercial syndrome that correspond to ensuring that transactions are win-win (invest for productive purposes, shun force, come to voluntary agreements, respect contracts, be honest) and taking the elements of the guardian syndrome that correspond to optimizing rather than maximizing the number of transactions (make rich use of leisure, respect tradition, be ostentatious, be exclusive).

This is a tricky business, which likely explains why the lending industry often simultaneously faces criticism for lending too much combined with criticism for lending too little. It also explains the need for tradition and for banks to be run by bankers working within organizations with a strong credit culture that has learned over time how to follow this hybrid ethical model. It also explains how a model which involved lending risk being taken on by purchasers of securitized loans and loan origination being done by sales oriented brokers quickly became a morass of fraud, gross incompetence and general ethical failure.

Some circumstantial evidence for lending being an ethical anomoly is the fact that Jane Jacobs almost never mentioned lending in her works (other than to complain about a lack of credit being offered to some people on occasion). But problems with lending fill the chapter of 'Systems of Survival' on syndrome mixing, and improvements to lending practices (credit circles, mostly) fill the chapter on how we can innovate while respecting syndrome boundaries.

Also, Jacobs lists lawyers as being a profession that is an ethical anomaly (because some lawyer's (barristers) fall under the guardian syndrome while others (solicitors) fall under the commercial syndrome and lawyer's tend to rank near the bottom of lists of least respected professions (pdf) - right along with bankers!

We saw, many posts back, that David Gauthier defined ethics as an impartial constraint. What we see is that in guardian activity one of the primary restraints is against breaking ranks with your fellow team members, it is a syndrome of solidarity which places the group ahead of the individual. In the commercial syndrome, one of the primary restraints is against placing the short run interest ahead of the long run interest, it is a syndrome of being the ant rather than the grasshopper. Successful lending requires that lenders maintain solidarity against breaking ranks and starting a race to the bottom with respect to lending standards. But at the same time, it requires lenders to make loans with an eye to their future repayment and a concern for the long run solvency of the bank through thick and thin.

* * *

In practice, making lending work without crisis over the long haul appears to mean running a banking system along Canadian/Australian/Hong Kong lines, with a small group of dominant, profitable, stodgy, well-established and tradition minded lenders that set the tone for the whole market that have no reason to want to upset the apple cart of the industry, and that limit their competition to areas such as customer service, and technological advancement.

In addition, government should ensure that new institutions do not do an end run around the system creating a 'shadow' system as happened in the U.S.

Regulations limiting who can buy and create banks also helps to limit competition.

Loans should, in the vast majority of cases be originated and held to maturity by integrated lending operations (i.e. banks and credit unions).

Finally, in certain high risk areas (such as mortgages to marginal customers) it may make sense for government to maintain a market with even less competition (such as Canada, with its 2 player insured mortgage market). Some areas (no doc / no down payment mortgages) should probably be outlawed entirely, as should charging (real) interest rates above a certain threshold.

In the long run, vigilance will be needed to fight against the financial instability hypothesis in which our success at preventing crises simply leads us to relax and cause the next crisis. History suggests that the best we can hope for is to stall as long as possible.

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