Is there a fundamental flaw in modern banking?
In November 2010 I submitted the following paper to the Independent Commission on Banking:
This was my attempt at a rational and impartial due diligence on the banking sector. It analyses the way that the very functioning of bank intermediation previously adopted an “Originate to Hold” model, but in recent years this has shifted to “Originate and Distribute”, also known as Securitisation.
Here are the main points:
1. The very structure of separating loan origination from ownership awakens deep rooted concerns about the exploitation of asymmetric information, namely Adverse Selection and Moral Hazard
2. The expectation of market operations to effectively regulate credit risk is shown to be unfounded, instead resulting in ill-conceived and excessive lending practices
3. The recent growth in debt levels therefore may be masking a more fundamental issue of declining debt quality, such as debt for consumption and Ponzi financing
4. Risk transfer practices mean that poor credit risk judgements are increasingly likely to be borne by unsuspecting counter-parties such as underwriters of Credit Default Swaps and central banks enjoying Government support
5. Finally, the climate for fraudulent activity is amplified as Government support for institutions with the potential for suffering losses (on securitised assets) increases.