NewWorld / U.S. ECONOMY
Issues of the 2008 Presidential Elections

The Risk of Finance

by John Berchet

The global financial system has experienced significant stress and volatility in recent times, contributing, in no small part, to the sharp slowdown in the U.S. economy. At the root of the trouble is a mishandling of the human element behind the equations. “John Berchet,” a financier responsible for developing and implementing investment strategies in a top hedge fund in the United States, writes about finance and risk, and proposes a few solutions.

In order to understand what is happening in the financial markets, it is useful to start with the basic role of a bank.
A bank takes in deposits from individuals who are looking for a safe place to keep their money and earn some interest on their savings. The bank, in turn, takes this money and lends it to entities looking to borrow money.  These borrowers might be companies looking to invest in building their business or they could be individuals looking for a mortgage loan to buy a home. The bank makes money by charging a higher interest rate to borrowers than it gives to savers. Now, this is not all that a bank does, but it is at the core of what a bank is all about.
 So, what are the risks for a bank? There is always the risk that a borrower will not pay back the loan to the bank. If a bank takes in $100 from you and pays you a 5% interest rate, the bank needs to generate $5 of income over the next year to pay back both your principal and interest of $105. If the bank lends the $100 to a company at a 10% interest rate, then if the company pays back its loan with interest, the bank earns $10 and, after paying you $5 of interest, the bank makes $5 of profit. But if the company does not pay back the loan because it goes bankrupt, then the bank has lost $100, and owes you, the depositor, $105.
What do banks do about this risk? They “diversify” their loan portfolio–in other words, they lend small amounts to many companies, so that if a few companies default and don’t pay their loans back, there are still many companies that do so and the bank is still able to earn a profit on the interest income earned. The financial world developed a process called securitization, through which the bank lends you the money but it utilizes certain types of “securities” to share that loan with many different banks, so that any one bank is only responsible for, say, 10% of your loan.

Growth and distance
In recent years, the securitization process has accelerated significantly, so much so that it is now quite possible that banks half-way around the world may be one of the lenders for your mortgage–a bank that you have never met. And this is where the financial system has gotten into trouble. It is now often the case that the bank who first lent you money is no longer the bank that holds your loan. The bank is often just a “servicer”–it takes your mortgage payments and passes them along to the real lenders–and this could be any of thousands of banks around the world.
Banks have much less of an incentive to really get to know you and to understand whether it makes sense for you to borrow the amount of money you are looking to borrow. In an effort to reduce risk by diversification, banks have tried to remove the risk of human relationships.
Much of this shift toward diversification has been a good thing. Some of the worst financial crises in history have been driven by the fact that banks were overly exposed to a few borrowers. The financial system is far less vulnerable to this problem than in the past. Even further, it is important to recognize the contribution of the financial system and financial innovation to broader economic welfare. The experience of history teaches that without adequate financial systems, substantive economic growth would not have taken place. Large-scale investments typical of modern market economies would have been impossible without the fundamental role of mediation played by financial markets, which brought about an appreciation of the positive functions of savings and risk sharing in the overall development of the economic and social system.
The contribution of the financial system to global economic welfare is due to the advantages offered by the securitization process. A mortgage allows an individual to finance a project, like buying a house. Through complex financial instruments, the risk of this project can be shared among different institutions/individuals and at the same time can be converted into a steady stream of income for elderly generations. The new financial instruments have created a network of economic exchanges that allow younger populations the hope of a brighter future, while allowing aging Westerners opportunities for a steady stream of retirement income. We cannot live without banks and a financial system, because they provide the resources for business and housing investment.
 What happened in recent months, however, seriously challenged the idea that the whole point of the competitive market system is to devolve control from individuals to an impersonal network. We need to recognize that economic responsibility is entrusted to individuals, not to competitive markets.
The market cannot substitute the individual. Financial markets are based on trust; ignoring this simply means ignoring the nature of the problem. During the recent financial crisis, financial markets froze completely because there was no trust among market participants. When the risks in the system are so spread out, when diversification is taken to this extreme, nobody knows where the risks lie and nobody seems responsible. The securitization process that started from the idea of splitting the risks among many market participants went too far and tried to remove the risk of human relationship and trust from the markets. By doing so, it challenged the nature of the markets themselves, creating a temporary paralysis of the whole financial system.

Proposals
What should be done? It’s a problem of education, of culture, firstly. As the Compendium of the Social Doctrine of the Church indicates, “Of itself, an economic system does not possess criteria for correctly distinguishing new and higher forms of satisfying human needs from artificial new needs which hinder the formation of a mature personality. Thus, a great deal of educational and cultural work is urgently needed, including the education of consumers in the responsible use of their power of choice, the formation of a strong sense of responsibility among producers and among people in the mass media in particular, as well as the necessary intervention by public authorities.”
Government intervention in helping regulate the financial markets can also help, albeit one needs to be aware of how such intervention can create other distortions as well. The government can, however, encourage a return to forms of “community banking” and “relationship banking,” which the financial system has moved away from. For example, governments could require that a greater portion of the loans issued remain with the original bank. So, if you borrow money from a local bank, that bank has to retain some portion of your loan, so that they always have a vested interest in making sure you are a good borrower. Moreover, when times are difficult, a local bank and local borrower are far more likely to find ways to resolve problems in a human way.
Secondly, with the disappearance of local credit unions and community banks in a world of larger, more national and international banks, governments could require financial institutions to have a local presence in communities in order to make loans to that community. Alternatively it might be useful to encourage the creation of local credit unions, that would serve as mediators between individual borrowers and these larger banks. These new credit unions would not have any deposits, but they would offer a place where individuals could be helped with their financial decisions and banks could be assured of an additional screen on prospective borrowers.
The purpose of all these proposals is to re-engage the needs of the human person, re-orient the financial sector away from an overly transaction-intensive, impersonal approach back to its “constitutive purpose... its original and essential role of serving the real economy and, ultimately, of contributing to the development of people and the human community.”