Wednesday, December 24, 2008
Structural Flaws in Financial Markets
Banking and finance have flaws that arise from time to time: Dangerous Lending Practices: An untenable situation may exist when: short-term loans are continously rolled-over for long-term needs; too many loans are denominated in foreign currency; lending requirements are relaxed to boost profits; loans are supported by shaky collateral, like equities; or the supply of loan funds comes from abroad, subject to sudden curtailment. Over-valued Assets: When securities or assets that are important to the well-being of the financial system become over-valued — priced higher than justified by a commonsense appraisal of intrinsic worth — a sudden readjustment may occur, wiping out collateral and roiling financial markets. Overly-Complex, Non-transparent, Poorly Understood Systems: Whenever systems become too complex to understand or to adequately control, a danger exists. An example would be Soviet Russia which became dependent on centralized micro-management of an entire economy. Hedge funds, such as Long Term Capital Management show weaknesses of non-transparency and complexity. In the financial derivatives market, major banks act as insurers of derivative contracts, without adequate accounting or transparency. Overly-Rigid, Highly-Regulated Systems: Sometimes systems are entirely dependent upon the government maintaining and adjusting rules that are needed for continued operability. An example would be the Savings and Loan system in the United States that was predicated upon the government controlling interest rates among competitors. With the advent of money market funds, the government lost the ability to maintain these controls and the system failed. The Brazilian Miracle ended with relaxation of economic discipline and increased government corruption. Another example would be the tightly-controlled foreign exchange system that served Brazil well during the "economic miracle" of the 1960s and 1970s. When the government changed in 1980, giving rise to a corrupt democratic system, the strict rules and essential discipline could no longer be maintained and the economy collapsed, opening a decade of economic crisis. A safe system is one in which every reasonable test of what might go wrong has an adequate response.