Thursday, August 19, 2010


In "Amar Bhide on the Stalinization of Finance" Yves Smith at directs us to an excellent article from the Harvard Business Review ...

Bankers of the World Unite (under one model)
The article discusses the loan activities of our financial institutions. Specifically it discusses how they have evolved from emphasizing decentralized decision-making (crucial for capitalist markets to function) to an increasing dependence on lending processes that resemble the centrally-planned economy of the Soviet Union. Personal one-on-one time with local bank loan officers, who traditionally studied regional conditions and developed a personal relationship with borrowers, has been replaced with mortgage brokers, who have to take their lending cues from abstract models developed by a few rocket scientists in the biggest financial institutions (which is also discussed in The Quants).

What makes this so dangerous is that the models and the programs they spawn are principally designed to benefit the narrow interests of market players who control the keys to the financial kingdom (the use of Net Present Value models in determining who can actually get home loan modifications, which I discuss here, is an example of this).

This is a troubling development when you consider that the patron saint of capitalism, Adam Smith, argued that the consumer should be the primary concern of a market economy. Protecting consumers was at the core of his "laws of justice" principle.

According to the article, the vast majority of market players in the financial sector depend on a standardized, model-reliant, process for accepting or rejecting loan applications. So, Why does this matter, you ask? Good question.

Why It Matters ...
As Smith points shifting lending from loan officers in local branches to standardized, score-based templates developed by faceless math geeks in New York has resulted in a "considerable loss of information": face to face assessment of the borrower (does he understand what he is getting into? Does he regard the loan as a serious commitment?) and knowledge of the community (How healthy is his employer? What is the outlook for the local economy?) have been lost in the process.

More importantly, as the article notes, reduced "case-by-case scrutiny has led to the misallocation of resources in the real economy." In the recent housing bubble, for example, lenders did little due diligence and "extended mortgages to reckless borrowers" because the models kept their focus on securing loan origination fees, and bonuses, rather than on the lenders actual ability to pay.

In a few words, because the models accepted the cooked up numbers of unscrupulous mortgage brokers the system became increasingly impaired as more and more brokers could give a dam as to whether the lender actually paid. Fixing the numbers to model is what mattered.

Today, our lending institutions continue to rely less and less on Adam Smith's "invisible hand" and depend more and more on a Stalin-like approaches to lending. Unfortunately these approaches bear "a troubling resemblance in its process and outcomes to a centrally planned economy."  

The actual article, and Smith's review and commentary, may be long for those of you who are short on time. But, as usual, they're worth the effort.

- Mark

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