"Des waerelds doen en doolen, is maar een mallemoolen,"

"Des waerelds doen en doolen, is maar een mallemoolen," engraving from Het Groote Tafereel der Dwaasheid, 1720.

"The actions and designs of the world go round as if in a mill." South Sea bubble financial crisis.

Saturday, July 23, 2011

Back to the future of lending

It sounds lovely. Bhidé is describing a world that once was:
Bank regulation, like lending, was once decentralized and judgment-based. Regulators relied mainly on examination of individual loans rather than capital-to-asset ratios. A typical bank exam would include scrutiny of every single business loan and a large proportion of consumer loans. Capital adequacy was a matter of judgment: examiners would figure out how large a buffer a bank ought to have, taking into account its specific risks.
But is he suggesting we should go back to the good old days of relationship lending ?
Smarter capital requirements – better Basel rules – aren’t the answer. Rigid, top-down uniformity is essential in the specification of weights and measures and the issuance of currency and coin. Bank lending and regulation, by contrast, must incorporate local knowledge, because, in a dynamic, unregimented economy, each borrower, loan, and bank is different (though some general guidelines can help). The seemingly objective top-down approach ignores the idiosyncratic nature of risk and assumes that one mortgage loan is like the next.
How do we ignore the financial revolution that took place supporting the use of "hard" over "soft" information? Incorporating local knowledge requires using soft information and is therefore costly. In contrast, hard information is easier to process. So the trend of information hardening that goes hand in hand with financial innovation and the use of mathematics in financial economics enhanced certain transaction based lending technologies, such as leasing or factoring, which benefited SMEs by raising credit availability. By the same token, this process is the cause of the increase in distance between small firms and their lender in the U.S. Consequently, distance is less an indicator of creditworthiness than before, which means that small firms at distance enjoy now a wider access to credit.

So this is a huge debate, which goes beyond regulatory issues. Too bad  Bidhé is not even mentioning it. 

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