BARCELONA – Are banks doomed as a result of the current financial crisis? The securitization of mortgages originally was seen as a triumph, because it shifted risk to financial markets, while taking deposits and making and monitoring loans – the purview of traditional banks – was regarded as narrow and old-fashioned. By contrast, modern banks would seek finance mainly in the interbank market and securitize their loan portfolios.
In theory, such banks should be immune to runs, because the interbank market is supposed to be extremely efficient, and risk would be shifted to investors willing to bear it. Deposits would be replaced by mutual funds, which, as we know, are also immune to runs, and the risk of structured investment vehicles (SIV’s) would be assessed accurately by rating agencies. All this financial engineering would avoid the obsolete capital requirements that burden banks’ operation.
The current crisis killed off this optimistic scenario. The interbank market has almost collapsed, because banks do not trust each other in the same way that we tend not to trust an eager seller of a second-hand car.
This is a textbook market failure. The origin of the problem is uncertainty about banks’ exposure to sub-prime mortgages, the risks of which have been carelessly assessed by rating agencies due to conflicts of interest. Northern Rock in the United Kingdom has been a victim of this modern banking strategy, as has Bear Stearns in the United States. Others may follow soon.