Bank Lending Decisions, Asymmetric Information, Adverse Selection, and Moral Hazard.

Minsky (1975, 1982, 1986) supported the position that stability destabilises. In analysing the development of the economy across the post-war period he proposed a basic theory that captured Schumpeter’s (Schumpeter, 1986) dynamical change in the system that involves dynamical forces that are so explosive that they require constraint. This constraint was proposed in the form of institutional ceilings and floors that create a safety net for the economy. The problem with this approach is that the success of the constraints in achieving stability altar the behaviour of the participants in a manner that leads to “unsustainable speculative euphoria” in what Minsky (1986) called his financial instability hypothesis. In this system, each boom will build in intensity leading to an inevitable crash that will test the safety net. This system cycles across time with the crises becoming more unstable, more frequent and more severe until a total collapse is possible.

Banks primarily exist for the purpose of allocating funds gathered in the form of short term deposits and converting these into longer term loans. This process changes liquid funds into less liquid and riskier forms of capital (Fama, 1980; 1985; Diamond & Rajan, 2001). In consolidating depositor funds and providing credit, banks and related financial institutions reduce the amount of monitoring required in the allocation of capital (Gorton and Winton, 2003). This process lowers the overall cost of redistributing capital to its most effective use (Leland & Pyle, 1977; Diamond, 1984). The counter side to this benefit is an increase in risk to the bank which is compensated through its profit margin. This risk comes in the form of an imbalance in liquidity. Many banks have a greater liquidity of liabilities than of their assets. In many instances, the assets held as capital by banks a long-term are prone to market risk leaving the bank vulnerable to runs and market fluctuations. For this reason, banks can fail if they are unable to retain ongoing lines of credit to account for depositor withdrawals as well as due to large-scale repayment failures from their clients as happened in the 2007/2008 period. Instances where depositors have made runs on the bank can be started because of unsound economic conditions or even rumours. These scenarios can lead to even sound firms being left in a position that is insolvent as they are forced to sell assets to cover the withdrawal of funds to their depositors at an unfavourable rate(Diamond & Dybvig, 1983).

Minsky analysed the financial innovations created by profit-seeking firms, he noted that many of these within the US were constructed in a manner that was designed to circumvent the constraints imposed through the New Deal. The federal funds market for instance reduced the Fed’s power to curtail bank lending. At the same time the introduction of deposit insurance and other protections allowed the banks to believe that they were safe and that their risk was lowered. This consequently led to the banks implementing poorer liquidity controls (Minsky, 1957), a further development was seen through the development of securitisation. Banks could move interest rate risk away from the balance sheets and simultaneously reduce capital requirements leading to a scenario that resulted in the 2007 global financial crisis.

Regulatory intervention has impacted the banking industry throughout the globe and the differing degrees a competition that have resulted can be compared across countries. Throughout the early half of the 20th century and up until the mid-1960s it was common practice to limit competition within the banking and finance industry, the argument in support of this practice was one of consumer protection. Governments argued that excessive competition would lead to banking failures. The result was an increase in regulations governing deposit rates, capital allocation, where banks could set up branches and constraints on mergers between financial institutions. The reasons for this derived from a widespread belief that there is a trade-off between competition and financial soundness. In this thesis, intense competition increases the incentives to issue more risk and to engage in more risky projects (Keeley, 1990). Capital controls are introduced to limit excessive risk-taking (Hellman, Murdock & Stiglitz, 2000) in this model.

Others including Allen and Gale (2003) have suggested that regulation is one dimension of an all-encompassing information asymmetry. In their model, a more chaotic and multidimensional relationship exists between the stability of the financial system and competition within it. Information needed to mitigate the moral hazard problem and adverse selection comes at a cost to acquire. This cost acts as a strong endogenous barrier limiting market entry and in the model allows the entrenched firms (Broecker, 1990) obtain a monopoly level profit achieved through rent seeking. This is investigated in more depth by Dell’Ariccia (2001) following the work of Dell’Ariccia, Friedman and Marquez (1999). In this work, it was argued that competitive equilibria cannot maintained due to the failure to allow the introduction of new firms and the consequential stifling of new innovation. Shaffer (1998) provided evidence that new firms have to compete through increased risk. The imposed barriers to entry place before new firms by the incumbents requires the new firms to seek higher profit through risk-taking in a manner that could lead to systemic market failures.

Sharpe (1990) put forth a hypothesis that information asymmetries can be exaggerated through the banks repeated dealings with long-term customers or clients. This practice was known as “relationship lending”. Rajan (1992) demonstrated that banks use this relationship to lock customers into ongoing arrangements that allow the firm to maintain a monopolistic level of information on their clients. Petersen and Rajan (1995) propose that this information asymmetry coupled with the cost of obtaining information through the marketplace leads to a reduction in competition in the short-term. They propose that deregulation of the financial services industry would provide for greater competition between the banks opening up the scope for innovation within transactional lending. Not all authors agree and others (Boot & Thakor, 2000) counter this argument stating that capital market financing reduces bank competition. They propose that capital market financing leads to more limited opportunities for relationship lending and a weaker financial sector.

The banking industry, particularly in the US has been changing markedly since the mid-1980s. The combination of deregulation in consumer banking markets coupled with international competition on interest rates led to what Minsky referred to as money manager capitalism. Wray (2009) went as far as to call the second half of the 20th century the “Minsky half-century”based on the nature of these changes.

Further changes to the regulatory structure of the financial institutions including increased liberalisation in the structure of banks with the ability to start nationwide branches resulted in a significant decrease in competition with many smaller banks forced to either merge into larger conglomerates will go out of business. This was coupled to the introduction of the BASEL accords in 1998. These changes altered the capital requirements needed to be maintained by the financial institution with the result that banks moved from highly regulated activities into increasingly risky off-balance-sheet investments.

Changes within the European union including the introduction of the common currency, the euro further created a series of changes with a widespread introduction of a wholesale banking market throughout Europe (Berger, Kashyap & Scalise, 1995). The suspension of the Glass–Steagall Act of 1933 opened up new markets for banks. The repeal of this act led to the introduction of new financial services that firms previously were blocked from offering. This not only opened up increased competition between the banks and other investment firms and insurance companies but changed the nature of relationship marketing within banks, allowing them to increase their monopoly on information and gain further advantages and consolidate their existing positions. This information asymmetry would introduce advantages based on size and a non-linear manner.

In the manner predicted above, the extensive wave of deregulation throughout the 80s within the US led to a run of merger and acquisition activity in the following decade. This phase of M&A consolidated the numerous smaller banking operations into a small number of large firms. The US was not alone in this process and is severe reduction in the numbers of banks occurred within the majority of industrialised countries. Those fearing the loss of regulation argued that the anticompetitive effects would negatively impact the consumer. Berger and Hannan (1989) presented strong evidence that consumers remain unharmed and that competition was not weakened in this progression. In their paper, they offered a negative correlation between the concentration of local banking and the level of deposit rates provided by consumers.

They argued that the evidence indicated a positive effect. It was postulated that larger financial organisations gained a level of efficiency over their smaller former rivals. The gain in efficiency as been argued by several other authors who support a similar position to provide a more than adequate offset for any loss of competition (Berger, Kashyap & Scalise, 1995; Focarelli, Panetta & Salleo, 2002). Although the overall position of deposits and loans remained favourable, the distribution was not symmetrically redistributed. The newly merged banks increased overall lending but at the expense of a contraction of credit to smaller clients in favour of large organisations banks (Berger et al., 1998).

In both the short and medium term, the consolidation of many of the smaller firms offered increased efficiency in the merged bank. For the most part, the efficiency extended across the processes on offer from the acquired bank. Overall, the clients of the banks as depositors benefited from this increase in efficiency (Focarelli & Panetta, 2003).

Where to?

Predicting the future is precarious at best but there are aspects of the banking industry that can be clearly seen to be causing change going forward. As the world globalises, international competition has opened new markets and started to redefine the financial services industry. This has itself led to a wide push for regulation, some local and more frequently across global boundaries. Most importantly, innovative new technologies are redefining the marketplace. The introduction of digital currencies to the international environment coupled with generalised information technology innovation are redefining the marketplace. New competitors from distributed systems such as bitcoin to more traditional innovative information technology players such as PayPal are starting to change the nature of money and the underlying market structure.

Each of these conditions have been leading to increased competition within the financial industry, especially banking. In many ways we could expect to see a wave of mergers and acquisitions along the lines of consolidations that occurred in national markets as a global banking conglomerates form. This would be expected to lead to a combination of larger and more efficient banks acting internationally and the acquisition and assumption of less efficient organisations in underdeveloped areas by the currently more efficient firms in the developed world (Focarelli & Pozzolo, 2005).

The primary consequence of technical innovations, especially in information technology is the ease of storing and distributing information. At present, it remains uncertain how this wave of innovation will impact problems such as adverse selection and the monopolistic retention of information stores. Many specialist information providers have been filling niches that came from the information advantage obtained in relationship lending. As these providers increase their scope, the informational advantage of asymmetric information stores will diminish. From the perspective of a bank making a lending decision, it is likely to become less profitable to other non-bank entities and to the lending market. This is demonstrated through the rise of peer-to-peer lending and Internet lending providers. It is clear that one of the results of this form of disruption will be the enlargement of local credit markets reducing the role of small to medium banks. These firms are likely to lose out both to small specialised co-op’s operating peer marketing as well as to large globalised firms.

Globally it would be expected that regulation will continue to allow more competition (Kim & Santomero, 1988). As we enter an era of non-bank based finance, more importance is being attributed to the market evaluation processes (Detter & Fölster, 2016).

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