Banking = risk pooling + maturity transformation
The natural downside to my tendency to write something stream-of-consciousness style and post it immediately is that I read it back and realised how what I’ve written is not terribly coherent. But it often gets me somewhere, so I’ll keep doing it.
Let’s begin again with the point that the non-financial sector wants to hold short-term, low-risk and liquid financial assets, and want to borrow in order to invest in long-term, illiquid and higher-risk non-financial assets. Two things need to happen to achieve this: you need to transform maturity and reduce risk. In theory non-financial companies could just issue lots of very small short-term bonds and we could all buy a little debt from each company and thus be diversified. But this isn’t very efficient, kind of like running your own stock index fund isn’t very efficient. Furthermore, index funds only work if there is someone out there actually trying to allocate capital, because if every fund is an index fund then by definition nothing would happen. I’m guessing we don’t all have time and skills to be underwriters, just like we don’t all have time and skills to pick stocks. Banks accomplish both the functions of active and passive investment, but for debt rather than equities.
This is all fine and dandy, but the problem is that risk-pooling only works with uncorrelated risks. Introduce correlation into the system, and you have failed to diversify. And that is why it is so important to avoid the expectation that aggregate demand may fall – as it introduces risk that cannot be diversified away from. You can turn all the myriad risks that may cause a particular company to fail (or for someone with a mortgage to lose their job) into something super-safe, but you can’t do that with AD. The amount of equally risky investment that can be funded with super-safe debt has to fall if uncertainty over future AD increases.
The corollary of this is that if our preference for low-risk short-term financial assets increases relative to our preference for long-term illiquid real investments, you essentially increase the negative consequences if the system is hit by a correlated shock. The greater the divergence between the desired characteristics of those two assets classes, the greater the necessary adjustment to achieve a new (and likely lower investment) equilibrium when such an event strikes.
You can throw an awful lot at an economy without its financial sector failing – so long as expectations of aggregate demand remain stable. But insofar as they don’t (due to incompetent central banking and widely-held false beliefs about monetary policy) then the wider the divergence between the risk and maturity profile of the projects we want to borrow for and the profile of the financial assets we want to hold, the deeper the crisis when a negative AD shock hits.
My suspicion is that we have regulated the financial system in such a way as to increase that divergence – and we need to think a lot more carefully about the differences between the desired characteristics of financial and non-financial assets (rather than just the structure of financial assets) when designing a regulatory system. I don’t think that bad financial regulation ’caused’ the Great Recession, but it exacerbated the effects of the proximate cause – which was falling aggregate demand.