Do derivatives make the financial system more efficient?

Sometimes it’s taken as a given that there wouldn’t be two parties trading derivatives, if the trade didn’t make both parties better off.   Because the existence of the trade counts as the evidence of efficiency, it’s not uncommon to see conclusions like the following:

[D]erivatives are used by financial institutions and corporations to adjust their exposure to particular financial risks, such as the default of a borrower or wild swings in interest rates. Both in theory and practice, these products have made the hedging and exchange of risk in the financial system more efficient.

It is clear that one of the implicit assumptions in the theory underlying the claims that derivatives make the financial system more efficient is that the parties to the trade have similar information. It is also abundantly clear that in practice this is not always true – as documented in recent lawsuits derivative markets are rife with asymmetric information.   Another issue is externalities – it is likely that the systemic effects of trade in derivatives are not taken into account by the counterparties to any given trade. For these reasons I think the question of whether derivatives make the financial system more efficient merits more careful analysis.

In my view, while there are many circumstances in which derivatives enhance efficiency, one cannot make a general statement that derivatives contribute positively to economic efficiency. In particular, our current derivative markets are very successful at transferring credit, interest rate and even liquidity risk (via collateral requirements) out of the financial system and onto the real economy. The question that must be asked is whether we want the real economy to bear these risks or whether we are better off forcing the financial system to bear these risks.

I’m going to propose a theory:  The role of financial intermediaries is to act as the economy’s managers of the risks involved in lending.

Traditionally there are two principal ways that intermediaries manage these risks: the first is to make a loan and carry all the risks of the loan on the balance sheet until the loan is paid off, the second is to sponsor a borrowing firm in its efforts to raise money on stock or bond markets. The first kind of intermediary is called a commercial bank, and because the bank carries the loans on its balance sheet until maturity, the traditional commercial bank can generally be counted on to manage the risks of lending carefully. The second kind of intermediary is an investment bank; traditionally an investment bank’s reputation for carefully vetting the quality of the stock and bond issues that the bank chose to underwrite was crucial to its ability to place the issue. Thus, by first approving the stock or bond issue and then by making a market in the stock or bond after it was issued, the investment bank played a very important role in managing the risk of the security.

We learned in the 1920s the dangers of market-based lending: because a stock (or bond) issue almost always relies on the imprimatur of a trusted bank or other gatekeeper, that gatekeeper can make a fortune by abusing the public’s trust. In many ways this is the same lesson we have relearned in recent years. While market-based lending has the advantage that it enables firms to raise very large amounts of money from a broad base of investors, this broad base of investors also generates the greatest weakness in market-based lending: it depends on gatekeepers who may or may not do their jobs well.

Thus, from the point of view of the economy as a whole the safest form of lending is lending that sits on the balance sheet of a bank until maturity. This lending is safe precisely because the bank is exposed to all of its risks, and therefore can be expected to manage them. There are a couple of provisos to this last statement. First of all, liquidity risk has always been something that individual banks can not manage entirely on their own. Reasonably stable banking systems have either developed means to deal with liquidity risk cooperatively or they have government sponsored support to help them through liquidity crises. Secondly, there is little historical or contemporary evidence that banks which have to manage interest rate risk without government support are willing to make long-term fixed rate loans. On the other hand, a very long history of banking and banking systems demonstrates that banks can manage credit risk and interest rate risk of three to five years very effectively.

Given this understanding that banking systems serve the economy by carrying the risks of making loans on their books – and indeed their main form of compensation, the net interest margin, is derived from the fact that banks carry that risk – we can now ask: Do derivatives make the financial system more efficient?

Let’s separate this into two different questions: Is the economy well served by credit default swaps that allow the financial system to transfer credit risk away from the banks? Is the economy well served by interest rate swaps that allow the financial system to transfer the risk of interest rates changes outside the banks?

Just as we learned both in the 1920s and more recently that market based lending is less reliable than bank based lending precisely because the bank is transferring the lending risk to other parties, we are likely to find that derivatives create a less reliable financial system than would be the case without derivatives precisely because derivatives make it easy for banks to transfer the risks of lending to others. Like the gatekeepers of market based lending, banks that transfer their risks using derivatives may at times do so in ways that abuse the trust of their counterparties.

In short if carrying credit risk on their balance sheets is one of the most important roles that financial intermediaries play in an economy, then making it easy for banks to transfer credit risk outside the banking system is likely to be destabilizing rather stabilizing for the simple reason that credit risk will end up being carried by entities that don’t know how to evaluate and manage it. This would be one reason to doubt that credit derivatives make the financial system more efficient.

Interest rate swaps are more complicated, because the US now has a financial system where it is considered normal for banks to make 30 year fixed rate loans. This system was created in the 1930s as a way to deal with a vicious cycle of homeowner insolvency: because so many homeowners couldn’t refinance their five year interest only mortgages when the principal payment was due, homes had to be sold and there were so many sellers that house prices were seriously affected – guaranteeing that even more homeowners couldn’t refinance. The solution to this vicious cycle was the thirty year fixed rate mortgage – except for the fact that there was no such product on the market.

I’m not sure when precisely the thirty year fixed rate mortgage became common, but the 1930s saw vast government efforts to support the residential mortgage market. In 1932 Herbert Hoover signed into law the Federal Home Loan Bank Act, which established Federal Home Loan Bank System, a mutual organization that raises money on public markets and stands ready to buy mortgages from member savings and loan banks. (It was modeled on the Federal Reserve System which through its discount window stands ready to buy commercial obligations from member banks.) In 1934 the Federal Housing Administration (FHA) was established. The FHA offered government mortgage insurance on loans that met the standards of the FHA. Because banks were reluctant to buy FHA mortgages, in 1938 the Federal National Mortgage Association (Fannie Mae) was created as a government agency that bought FHA mortgages. Somewhere along the line the thirty-year fixed rate mortgage became a staple of the industry. In the absence of substantial government sponsorship of this mortgage product it’s hard to imagine that banks would be willing to offer such mortgages or hold them on their balance sheets.

The savings and loan crisis of the 80s was caused by the fact that these banks were carrying 30 year fixed rate mortgages on their books and were completely unprepared to deal with the interest risk created by their long duration assets. (No bank can make money if it has to pay 10% on deposits and only earns 5% on its portfolio of loans.) The interest rate swap market – which was pretty clearly the catalyst for the more general growth of modern derivatives markets – developed as a response to the savings and loan crisis and the recognition by financial institutions that their long duration assets exposed them to interest rate risk. Interest rate swaps allow banks to convert their fixed rate assets into floating rate assets and thus have an important role to play in US markets as they are currently structured.

The savings and loan crisis can, however, be viewed as a sign that from a systemic point of view that 30 year fixed rate mortgages are simply too dangerous a product. Shifting towards a shorter duration mortgage product or one with some measure of floating rates (and there are many, many examples of such products abroad) might have been a better choice for the financial system. Thus the problem with interest rate swaps may be that they encourage individual banks to “manage” interest rate risk, when in fact it is far from clear that the financial system as a whole is equipped to deal with the aggregate exposure to interest rate risk that the 30 year fixed rate mortgage creates.

In short, the problem with derivatives is precisely that they allow financial institutions to transfer risk. In the case of credit derivatives the problem is that credit risk is too easily transferred away from the financial institutions that are specialists in credit risk to non-specialists who don’t really understand the risks they are carrying. In the case of interest rate swaps, the problem is that the perception that interest rate risk can be traded away leads to the growth of excessive interest rate risk in the financial system as a whole. It is not unlikely that when there is actually a significant jump in interest rates, many of the counterparties that are carrying that risk will be bankrupted by it and we will find that once again the government needs to step in as the derivative underwriter of last resort in order to prevent a chain of financial system failures.   (In fact, as I think about the case of AIG, this argument about the externalities of interest rate swaps seems to hold pretty well for credit derivatives too.)

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