Think Twice Finance

The Banking Crisis Rewrites the Textbooks: How Computers Reregulated the Banking System While We Slept. Part 2

In the most recent post, we considered the effect of computers on the liability side of bank holding company balance sheets. This post begins to examine the more sweeping and visible effects of computers on the asset side of the balance sheet.

During the past decade the profitability of banking was greater than anyone would have guessed at the outset of the period. At the beginning of the decade banks had been liberated from onerous bank regulatory restrictions limiting the banks from competition with each other and with other financial institutions. The textbooks say that the effect of this on banking profitability should be negative. While the total net worth of the banking system might be expected to grow (instantaneously) with the new opportunities deregulation presented the banks, competition should have eventually driven the majority of this value out of banking profits and into consumer surplus.

That is, consumers were expected to be the main beneficiaries of a gradual decline in the cost of banking services as competition would drive out the old profits from restraint of trade created by the abolished government restrictions. And with the internet and the computer driving events, it was anticipated that this would happen sooner rather than later.

This crossover of banks into new lines of business did indeed occur quite rapidly. But as always with changing regulation, the unintended effects of this deregulation were not the effects regulators expected.

Two unintended effects were paramount. First, deregulation liberated the banks to use more of the whole economy’s balance sheet as collateral. The economy’s balance sheet consists of real capital, land and human capital. Throughout the history of banking before 1970, only the first component, real capital, was an important source of banking collateral. However by the year 2007, real capital was the least important of the three sources of collateral. It was the computer that permitted this massive increase in the banks’ collateral base by enabling the banks to manage relationships with a borrowing population several levels of magnitude greater than before. During the Enron bankruptcy, for example, the record revealed that the company had more that 1,400 bank credit relationships. How many of those banks could possibly been making an informed lending decision? The court decisions following the collapse of Enron suggest the number is roughly half a dozen. Thus customers in the year 2002 had many more banking relationships than had historically been the case, and most of these bank lenders didn’t know their borrowers.

The reverse was also true. A large bank in 1970 might have 200 important borrowers. By 2007 that number might be closer to 200 million borrowers. The mortgage, in particular, became king, leading banks to combine the debt of many small borrowers into large chunks that they hoped they understood.

Second, the riskiness of bank balance sheets ceased to be an important issue because banks increasingly took their risks in the non-bank subsidiaries of bank holding companies. Thus the bigger risks were “buried” in the holding companies’ non-bank subsidiaries, where the public knew their government bore no responsibility to protect them. The public also assumed their government would not permit these alternative investments to become material to the functioning of the economic system itself.

So for example, money market fund investment in instruments that could suffer substantial capital losses were assumed impermissible, and vehicles that were plainly risky, such as private equity and hedge funds, were viewed as a sort of sideshow for the rich that would not in the end affect bread-and-butter businesses like, for example, child care.

But with the aid of computers, banking entities thought they could evaluate many small risks en masse. The rating agencies and their computers were viewed as “honest brokers” who could safely perform this task.

Thus banks became far more important than before, far riskier than before, and middle class families remained blissfully unaware that these changes had any likely impact on their daily lives. This assumption has now proven disastrous.