Selection à la Banks

19 November 2009 at 8:39 am 2 comments

| Lasse Lien |

Ideally, the competitive process would select for productivity. It doesn’t actually do that. Presumably it selects for expected profitability, which is close enough — assuming market power isn’t too common. What has the economy been selecting for in the past year or so? The state of low demand means that it’s harder for firms to finance operations and investment, and firms depend more than ever on external capital. For most firms this means the bank. So banks’ credit decisions will to an unusual degree decide who gets to grow and who has to shut down. Simultaneously, banks are cutting back on credit — so which firms will the banks select? Since banks have no upside, they will ration credit on the probability of losses. This is clearly a worse criterion than expected profitability because it involves a degree of risk aversion that cannot be healthy. Presumably new firms, high-debt firms, small firms, and firms with mainly intangible assets can all be selected out (or unduly constrained in their growth), not because they have low productivity or low expected profitability, but because large, established, low-productivity, low-debt, tangible-capital firms represent a somewhat lower credit risk.

Hopefully, the period of bank-driven selection will be short and expected profitability will be restored. The only thing worse, I guess, is selection by lobbying productivity (or scale).

Entry filed under: - Lien -, Bailout / Financial Crisis.

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2 Comments Add your own

  • 1. steve  |  22 November 2009 at 10:07 am

    “This is clearly a worse criterion than expected profitability because it involves a degree of risk aversion that cannot be healthy.”

    Hmmm…. not so clear to me. Gold and commodities are screaming inflation, bonds and housing are saying deflation, add some regime uncertainty. Risk aversion seems like exactly the right strategy.

    Perhaps you mean you think another enviornment where banks can take greater risks is healthier. If so, then I agree. However, I believe that a large reduction in the currently existing risk is what gets us to that better place. If this is true, then the banks current risk aversion is healthy in the sense that it moves us in the direction of the place we want to be.

    “large, established, low-productivity, low-debt, tangible-capital firms represent a somewhat lower credit risk”

    I am not sure why low-productivity makes you a lower credit risk. Perhaps large, established, low-debt, tangible-capital makes you low-productivity. But, this doesn’t seem correct either.

  • 2. Lasse  |  23 November 2009 at 3:51 am

    Thanks for commenting Steve.

    First, about risk aversion. My point is not about the level of risk premiums. You can implement any level of risk premium you think is correct and still have expected profitability as the selection criterion. My point is that because banks don’t have an upside, they will select on something other than expected profitability. This other criterion is inferior to expected profitability, exactly because it does not factor in an upside. For any level of risk premium you want, it will still be biased.

    Second, my point is not a critique against banks, at least not directly. I think banks should worry primarily about credit risk (and if they had been better at it, we wouldn’t be having this discussion), instead my point is that a cost of the current situation is that we get a different kind of selection process.

    Third, I guess I could have formulated this a bit clearer. I did not mean to say that low productivity makes you a better credit risk, only that banks will have very weak incentives to include productivity in their rationing decisions. So they are quite likely to provide credit to a low productivity firm with a low credit risk, and let a higher productivity firm with a higher credit risk go under (or be severely constrained).

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