A major intellectual blind spot in academia and among policy makers is the belief that making markets more liquid is always and ever a good thing. That bias may come from Arrow-Debreu, in that too many economists seem to think that “completing markets” (as in moving towards the unattainable A-D fantasy of having markets in everything, including whether you will be late to your doctor’s appointment three weeks from Tuesday) is desirable.* Or it may come from the fact that financial economists would have little to do if, say, the only actively traded markets were commodities futures, currencies, government bonds, and money market instruments.
Amar Bhide, now a professor at the Fletcher School and a former McKinsey consultant and later proprietary trader, questions the policy bias towards more liquidity in financial markets. Officials (and of course intermediaries) favor it because they lower funding costs. Isn’t cheaper money always better? Bhide argues that it can come with hidden costs, and those costs are sometime substantial.
He first took up the argument in a 1993 Harvard Business Review article, “Efficient Markets, Deficient Governance.” Its assessment was pretty much ignored because it was too far from orthodox thinking. He started with some straightforward observations:
US rules protecting investors are the most comprehensive and well enforced in the world….Prior to the 1930s, the traditional response to panics had been to let investors bear the consequences……The new legislation was based on a different premise: the acts [the Securities Act of 1933 and the Securities and Exchange Act of 1934] sought to protect investors before they incurred losses.
He then explained at some length that extensive regulations are needed to trade a promise as ambiguous as an equity on an arm’s length, anonymous basis. Historically, equity investors had had venture-capital-like relationships with the owner/managers: they knew them personally (and thus could assess their character), were kept informed of how the businesses was doing. At a minimum, they were privy to its strategy and plans; they might play a more active role in helping the business succeed.
By contrast, investors in equities that are traded impersonally can’t know all that much. A company can’t share competitively sensitive information with transient owners. Stocks are also more liquid if ownership is diffuse, which makes it harder for any investor or even group of investors to discipline underperforming managers. It’s much easier for them to sell their stock and move on rather than force changes. And an incompetent leadership group can still ignore the message of a low stock price, not just because they are rarely replaced, but also because they can rationalize the price as not reflecting the true state of the company compared to its competitors, which is simply not available to the public.
Bhide’s concern is hardly theoretical. The short term orientation of the executives of public companies, their ability to pay themselves egregious amounts of money, too often independent of actual performance, their underinvestment in their businesses and relentless emphasis on labor cost reduction and headcount cutting are the direct result of anonymous, impersonal equity markets. Many small businessmen and serial entrepreneurs hold the opposite attitude of that favored by the executives of public companies: they do their best to hang on to workers and will preserve their pay even if it hurts their own pay. Stagnant worker wages and underemployment are a direct result of companies’ refusal to share productiivty gains with workers, and that dates to trying to improve the governance problems Bhide discussed by linking executive pay to stock market performance. That did not fix the governance weaknesses and created new problems of its own.
It may be that the halo effect of America’s successful equity markets facilitated the sale of dodgy debt instruments. Bhide turns to the problems with mortgage securitization in his current paper. His core argument is that it imposes too much standardization on a market that requires customization and benefits from decentralized decision-making:
I argue that the liquefaction of small loans (of whatever opacity or complexity) has features beyond just the greater use of IT that impose significant hidden costs. Buyers of traditional corporate bonds expect underwriters to carefully analyze the creditworthiness of each borrower. But the mass liquefaction of small loans limits comprehensive scrutiny of individual borrowers. Instead explicit statistical discrimination (Phelps 1972) is used to select and price credits. Centralized data bases and computers do reduce the costs of statistical discrimination but this is not the central differentiating feature of the underwriting process.
Similarly, liquefaction of small loans encourages standardization of loan terms (i.e. mechanistic instead of case‐by‐case contracting). Liquefaction also requires a wide dispersion of creditor interests. And dispersion encourages a mechanistic response to delinquencies instead of case‐by‐case renegotiations or restructurings.
Securitization therefore has a downside beyond the “weakening of incentives to perform due diligence,” namely that mechanistic underwriting, contracting and responses to defaults ignores borrower specific facts and circumstances. Credit‐screening is thus routinely impaired and loan contracts aren’t well matched to the specific circumstances of borrowers. And, just as mechanistic underwriting can lead to the unwarranted extension or denial of credit at the outset, mechanistic foreclosure can lead to the unwarranted continuance or termination of loan contracts.
This mirrors one of my pet peeves: that originate-to-distribute lending results in information loss. In the old days of banking, it was understood that the local branch had knowledge about the community that it would use in credit decisions. Is the town’s economy vibrant? Is the guy who runs the local hardware store a good businessman? If so, someone who works for him might be a good credit risk. But that ability to assess job stability has been seriously degraded in centralized, score-based lending approaches.
Bhide also invokes Hayek to diss securitization, arguing it embodies the sort of centralized, low information decision-making that Hayek associated with central planners.
I strongly urge you to read his paper in full. Bhide will be submitting it to a journal, so NC readers are very much encouraged to help him debug his argument! You can also download it from SSRN.
*In ECONNED, we discussed the Lipsey-Lancaster theorem at some length. It show that moving closer to an idealized state does not always produce better outcomes and often can lead to worse ones.