Investment–Commercial Bank Relationship

In my attempt at a foray into explaining why Germany didn’t suffer a housing boom, I wondered why economists put so much emphasis on the role of German and French banks in providing liquidity at low interest to the peripheral countries. Paul Krugman provides a partial answer,

[Y]ou should think of it as largely taking the form of bank-to-bank lending. E.g., German Landesbanken buying covered bonds issued by Spanish cajas, with the cajas in turn using the money to finance real estate purchases.

A ‘covered bond‘ is essentially the same thing as an asset-backed security (ABS’), and during the boom most of these assets were mortgages. In a subtle sense (i.e. the initial step), I think Krugman has it backwards, though. The Spanish cajas (regional banks) and larger commercial banks would extend a loan, and when enough of these were aggregated they would be securitized. These were sold to other banks, such as Deutsche Bank, transferring the risk to these banks — ideally, risk is reduced because the pool of loans is heterogeneous (in terms of risk of default). In effect, it’s as if the loan originator is paid back in cash, allowing the same bank to extend a new loan. In other words, it lifts certain constraints on lending (it also further reduces interest rates, since it reduces risk).

It was the same process in the United States. Commercial banks and other ‘loan originators’ extend loans based on the capital available and the liquidity of their balance sheets, and these were securitized and purchased by investment banks (and government sponsored enterprises [GSEs], like the now infamous Fannie Mae and Freddie Mac). (At this point, these were usually re-sold to other financial institutions, and/or repackaged as collaterized debt obligations [CDOs] — where the ‘mezzanine’ tranches [typically, worst quality loans] were organized into even larger pools of the same type of bonds.) By injecting commercial banks with liquidity, investment banks fueled the machine by giving them the means to extend an even greater quantity of loans.

Krugman’s story isn’t the whole story, but it reveals an important part of it. If someone is wondering what a free banker thinks of it all, I caution against throwing the baby out with the bathwater. Today’s financial industry is shaped by its constraints and incentives. In a world with competitive money, commercial banks would be limited by their deposits and the volume of circulating outside money (specifically, that portion of outside money composed of their notes). Let’s suppose that an investment bank purchases an ABS; the cash used to buy the asset can either be (and it doesn’t matter if it’s physical cash or electronic cash denominated in a particular currency),

  1. The bank’s own banknotes, which means that the volume of outstanding banknotes actually falls (banknotest → loant+1 → banknotest+1 → sale of ABSt+2 → banknotest+2, where banknotest = banknotest+2);
  2. Other banks’ banknotes, which our bank uses in inter-bank clearings (either to meet returning obligations or to redeem for other banks’ outside money [assets], some of which will be met by our bank’s own notes).

So the relationship between investment and commercial banks isn’t necessarily unstable. It’s really a function of the monetary regime. This doesn’t mean that a free banking system is necessarily stable under all conditions, which is something I realized after reading Michael Lewis’ The Big Short — which I plan to review, so the following might be repeated and expanded upon. Given how new some of the asset markets were during the boom, in many cases there wasn’t a lot of heterogeneity amongst investors, which means that there wasn’t a lot of arbitrage. In turn, this caused a reduction in risk-aversity which otherwise might not have taken place. Some of this might have been mitigated had there been more competition between rating agencies (another thing which is government-constrained), but some of it also had to do with the age of the market — we can’t forget that these are evolving institutions, which presupposes failure.

We might be able to say that the boom might not have been as large as it was, or maybe it would have taken a different shape (a wider variety of investments — investment in mortgages was driven, in large part, by capital regulations), but I’m not claiming that the free market alternative is perfect.

7 thoughts on “Investment–Commercial Bank Relationship

  1. Blue Aurora

    You need to read Richard Koo’s The Holy Grail of Macroeconomics, as Koo himself diagnoses a balance sheet recession in the time period that you are talking about. I think it would have made your analysis more powerful if you had cited Richard Koo.

          1. Blue Aurora

            He talks about Germany to a small extent in The Holy Grail of Macroeconomics, if my memory serves me right. I’d check your copy of that book.

  2. Leonardo IHC

    You must add that covered bonds (like other ABS depending on the asset) have special treatments in balance sheets. This, in our no-longer-market burocratic banks, implies certain credit policies as you pointed above.


Leave a Reply

Your email address will not be published. Required fields are marked *