Simplified Finance: Part II

In my earlier post (see Part I) on this subject, I talked about an ultra-simplified financial system that “has a payment system, a spot foreign exchange market, “pure” life insurance companies, an equity market and practically nothing else ... no banks, no central banks, no debt markets and no derivative markets.”

I did emphasize that my speculation was completely ahistorical. I did not perhaps make it clear that I also assumed fairly well developed legal systems and governance structures without which equity markets are a complete non starter. In early stages of economic and financial development, it is difficult to create equity markets that work. I have no quarrels with the claim (for example at the Lin roundtable) that stock exchanges are pre-mature at that stage of development.

Coming back to the minimalist design, the next thing that one would want to add would be a debt market. First a government bond market and second a corporate bond market.

I mentioned in my first post that the government bond market is as above all a concession to the practical reality of governmental profligacy. Many people that I talk to think of government bond markets as mechanisms that increase the asset allocation opportunities for investors and allow them to choose less risky portfolios if they like. I think that a lot of this is money illusion. Government bonds are in fact very risky because of the ever present threat of inflation and hyper inflation. The tail risk of bonds is greater than the tail risk of equities.

The introduction of government bonds does not by itself require the introduction of any other markets including interest rate derivatives. These derivatives are needed when you have leveraged financial institutions and in the minimalist design so far there are no such institutions.

Adding a corporate bond market is more complicated because it creates leveraged entities. It is difficult for leveraged entities to exist without derivative markets particularly commodity and currency derivatives. We could avoid this by having only long term corporate bond markets. The absence of financial institutions and short term debt markets would automatically limit the leverage of firms and then it may be possible to get by without derivative markets.

More troublesome is that adding corporate bonds without adding banks and other financial intermediaries would create a strong bias against small firms. It is easier for small firms to access equity markets than it is for them to access corporate bond markets. To level the playing field, it may be necessary to add bank like intermediaries that would lend to smaller enterprises. But once we add leveraged financial intermediaries, it is impossible to have a simplified financial system anymore as I shall discuss in the next part of this series.

Posted at 6:22 pm IST on Tue, 14 Jul 2009         permanent link

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