The Future of the Financial System
2: Leaner and Smaller
January 12, 2012
(This item originally appeared in Forbes.com on January 12, 2012.)
What is a “financial system?” It is a system that provides finance.
What is “finance”? It is providing the money to undertake a plan. To
whom is “finance” provided to? Non-financial companies and
The capitalist system works something like this: one person has a
good idea, but no money. Another person has lots of money, but no
good ideas. They get together, and create something new. The
financial system facilitates this process.
The “idea” might be a startup venture. Or, it might be expansion of
an existing business, such as adding new restaurants to a restaurant
chain. The “person with an idea” might be a penniless Silicon Valley
dreamer, or it might be the CEO of a Fortune 500 company.
Ideally, from the standpoint of the person with the idea and the
person with the money, this process would be done with as little
cost and effort as possible. We also want the people with the best
ideas to get the most money, and for poor ideas to remain unfunded.
The process by which this works is very simple. It hasn’t changed
much in five hundred years. There are two basic forms of finance:
debt and equity. There are also a few alternatives, such as
preferred equity and convertible bonds. But, even today, almost
everything is done with plain vanilla debt and equity – not much
different than it was done in 15th century Florence.
The “financial system,” by itself, doesn’t create any useful goods
or services. Its sole purpose is to facilitate the flow of capital
between those who have it and those who deserve it. (To be fair,
investment advice might be considered a useful service, albeit one
that is often overpriced compared to the benefits.)
The financial business should be, inherently, rather simple. It is
also something of a commodity business. Have you noticed that all
banks are basically the same? Consider the difference between your
experience as a customer of, say, Bank of America and People’s
United Bank (a regional Connecticut bank). Now consider the
difference between your experience as a customer of General Motors
and Mercedes, or Apple and Microsoft.
Recently, we’ve been thinking about the difference between today’s
financial system and what our ideal financial system might look
like. Today’s financial system is grossly bloated and consumes
enormous resources. It is not only parasitic, but in the process of
its parasitism, it creates many negative situations for the
A lot of “financial innovation” of the past few decades hasn’t
really provided any improvement on the centuries-old system of debt
and equity. Rather, the bankers discovered something interesting –
the more complicated they made things, the more they could take
advantage of their position as a middleman between capital providers
and capital end users. This led, for example, to the asset-backed
security, the mortgage-backed security, the collateralized debt
obligation, and eventually to the “CDO-squared” and even the
“constant proportion debt obligation,” a short-lived device that
will serve as the high-water mark of financial stupidity.
The idea behind these confections was that you could take debt of
middling credit quality and, by creating a hierarchy of loss, create
a synthetic debt of high credit quality. However, in practice, it
became a way of selling loans for more than they were worth, to
suckers (“institutional investors”) who would rather listen to a
rating agency’s paid-for opinion than do any actual research on what
they had bought.
Actually, banks had provided a similar service for centuries. It was
called bank debt, or a bank deposit. The bank would hold loans of
middling quality, and issue debt of (theoretically) high quality.
The difference with the ABS or CDO was that the bank was no longer
liable for the loss. Eureka! Now, banks could make any sort of loan,
because they weren’t subject to loss. They could stuff the end
investor with the loss.
We ended up with a situation where the end investor (CDO purchaser)
had little idea of what he had bought. The bank didn’t care, because
it wasn’t liable. The basic function that channeled capital into the
most deserving hands – the promise of profit and the fear of loss –
was disabled. The result, naturally, was gross misallocation of
As banks moved beyond their useful function – connecting people with
ideas to people with capital – their activities become inherently
destructive. People began to complain about banks’ effect on
society, through aggressive credit card or educational lending for
example. Any society, eventually, will aim to curb such destructive
To continue their position of privilege, in which they received more
and more resources while doing less and less for the economy, the
banks had to buy out the cops. The political system became more
corrupted. This also turned into a bonanza: not only were they able
to keep doing what they were already doing, within the private
sphere, but they could then channel resources from the public sphere
into their pockets. In other words, they could steal from taxpayers.
The quantities were enormous.
This takes the form of “bank bailouts.” It has been going on,
primarily via the IMF, since the 1970s. Today, the developed
countries are getting a taste of the plundering that the emerging
markets have suffered for decades. Witness Ireland, for example,
which had a manageable government debt/GDP ratio of 25% before the
recent crisis. It is now around 115%. How did that happen? The
government borrowed the money to pay off mostly foreign bankers on
their losses on private-sector loans.
On top of that, we have a great many transactions which amount to
buying from the government at very low prices, and selling to the
government at very high prices. Examine the conditions under which
the FDIC sold the bankrupt IndyMac Bank to IMB HoldCo LLC, for
An example of “selling at very high prices” could be the recent
promotion of Fannie/Freddie refi mortgages with very, very easy
conditions. Each refi involves the payment of an existing mortgage
in full – a mortgage which may be owned by a private bank. Indeed,
even the Federal Reserve’s promotion of very low long-term interest
rates (“quantitative easing”) has, as an effect, the promotion of
mortgage refinance, which again makes banks whole and saddles the
Federal Government, via Fannie and Freddie, with all the default
The latest Federal Housing Finance Agency estimate is that the U.S.
government will assume losses from Fannie and Freddie for $124
billion through 2014. It will probably be larger than that.
A similar sort of trick is being pulled right now regarding Greece.
Many complain that the various “bailouts” of Greece aren’t helping,
because they only add more debt to a situation caused by too much
debt. But those criticisms miss the point: the question is not
whether Greece will default – it will – but rather who owns the debt
when it defaults. The longer this can be delayed, the more Greek
debt, owned by private banks, matures and is paid in full, while the
new debt issuance is bought by governments. The German and French
taxpayer is gradually being left holding the bag.
This is not a “financial system.” It is merely a mechanism of
plunder. We will look into the issue a bit more in the future.