Ronald Coase and the nature of shadow banking
Ronald Coase famously began his article on the nature of firms by asking a novel and fundamental question: Why do we have firms in the first place? Why does anyone go through the trouble of organizing as a company instead of working individually?
Coase, who died at the age of 102 on Labor Day, was easily one of the most influential economic thinkers of the past 100 years. Perhaps ever. His focus was on how companies and markets really work, particularly in light of ubiquitous barriers to free and open exchanges.
So perhaps we should look to Coase for an explanation of our recent unpleasantness in the financial sector. What can Coase's teachings tell us about the structure of the financial system, the rise of shadow banking, the financial crisis and its aftermath? As far as I can tell, no one has really explored these questions.
But let's start with the Coasian basics, which means imagining a world without firms. Glen Fox once described this world in a Cato Institute paper on Coase:
Adam Smith's pin factory could operate as follows. One person could dig ore out of the ground and sell it to someone with a wagon and a horse. That person, in turn, could cart the ore to a port where they could be sold to a ship owner. The ship owner could sail to some other port and sell the ore to a smelter. The smelter could sell steel to a person who manufactures wire, the wire manufacturer could sell wire to someone who specializes in cutting wire to pin-like lengths. These pieces of wire could be sold to someone who sharpens one end to a point. This process could continue up to final delivery of pins to end-users.
From a certain perspective, this system looks highly efficient. After all, there would be constant market feedback, with information from prices flowing in at every step of production. So why don't we live in the world of universal independent contractors?
Coase's answer was that the constant bargaining necessary under such a system increased transaction costs.
Firms are organized to reduce these transaction costs by establishing ongoing relationships among owners of the factors of production. The pin factory vertically integrates at least some parts of the production—perhaps the cutting and the sharpening.
Exactly how much gets integrated into a single firm depends on the size of the transaction costs that can be avoided and the costs downsides of integration. Those costs include the possibility that managers will make mistakes because they lack market information about the pricing of inputs.
Very little attention has been paid, as far as I can tell, to how Coase's theory applies to both traditional banking and the rise of the shadow banking system. That's an odd gap in our thinking about banks, especially considering how influential Coase's theory of the firm has been in so many other areas.
What most of us think of as the traditional financial system was a system of credit intermediation made up of banks, insurance companies and pension funds.
On one side you had savers who wanted to preserve their wealth and earn some income from it. On the other side you had people who needed credit, largely for their homes or businesses.
The credit intermediaries served as brokers of sorts between these two sides. In the mid-1940s, banks, insurance companies and pension funds were responsible for around 100 percent of the credit intermediation.
The Coasian question here is: why have intermediaries at all? Why not a system in which credit is directly supplied to borrowers from savers? The answer is, of course, transaction costs.
A would-be borrower would have to track down a large number would-be savers; each of those savers would have to carefully review the borrowers' credit worthiness; both parties would have to research the right price of the credit to be provided.
The provision of credit would become a very expensive process. By organizing banks, we can avoid a great deal of these costs.
So what happened? As everyone now knows, a great amount of credit intermediation is now conducted by what we call the shadow banking system.
A paper published by the New York Fed last year reported that the traditional institutions now account for just 47 percent of credit intermediation (which is actually up from the low of 40 percent hit before the financial crisis).
The institutions of shadow banking—money market funds, REITs, mutual funds. government-sponsored entities, off-balance sheet special purpose vehicles, some hedge funds, custodian banks, broker-dealers—account for 26 percent of credit intermediation (down from a pre-crisis height of 34 percent).
Looked at from the perspective of Coase's work, we can see this transformation as the result of the decline in transaction costs for credit intermediation.
In particular, the advent of securitization and trading of various types of credit instruments reduced transaction costs. Information about the price of various types of credit is readily available because of relatively liquid markets for credit. Bundling of loans creates diversification that reduces the cost to savers of investigating each loan separately. The work of credit rating agencies appeared to further reduce the cost of credit provision.
Gary Gorton's work on information-insensitivity describes this story.
The development of debt instruments that were information-insensitive meant that transaction costs were far lower.
Price discovery was as easy as referencing a credit rating, a coupon and figuring in a haircut. The traditional banking firm became less important and shadow banking arose in its place. Shadow banking, that is to say, was the alternative available when the rewards for integrated banking shrank due to falling transaction costs.
The financial crisis can be seen as the sudden perception that transaction costs were actually higher, particularly the cost of price discovery of asset backed securities. The initial results of this are well-known—a banking panic, illiquidity, several well-known failures.
What happened next is right out of the Coasian playbook: higher transaction costs led to mergers, acquisitions, and deeper integration. JPMorgan Chase engulfed Bear Stearns and Washington Mutual. Wells Fargo absorbed Wachovia. Bank of America took Countrywide and Merrill Lynch. The importance of the integrated firm came back with a vengeance.
Perhaps it's a stretch to claim that all of our recent financial history can be explained in the term Coase taught us to use when thinking about institutions.
But it's a shame more attention hasn't been paid to this line of thinking.
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