G20 London 2009

Market mystique: securitisation, regulation and failure of the banking model

by Salil  Sarkar

Article published on the 2009-03-31 Latest update 2009-03-31 20:05 TU

Brokerage house in Wuhan, Hubei province, China
(Photo: Reuters)

By today’s standards, the financial system was small. Back in the 1960s, finance and insurance together accounted for less than 4 per cent of GDP of the US.  Until 1982, the Dow Jones Industrial Average contained not a single financial company.

Sounds backward in the light of what goes on today? Maybe, but a real, material economy coupled to a tiny financial sector doubled living standards in the US in about a generation.

After 1980, deregulation became the fashion. Ultraconservative Hollywood actor and California governor Ronald Reagan became US president. Old-fashioned banking made way for wheeling and dealing on a grand scale.

Nowadays, finance and insurance account for 8 per cent of US GDP. That is more than twice their share in the 1960s. Besides their actual clout in the economy goes way beyond such figures would seem to depict. Similar pro-finance trends spread like wildfire from the US to the rest of the world - richer countries mainly.

“Securitisation” became a buzzword. Loans no longer stayed with the lender. They were sold on to others, who sliced, diced and mashed individual debts to synthesise new assets.

Subprime mortgages, credit card debts, car loans - all went into the financial system’s mixer machine. And financial wizards were lavishly rewarded for overseeing the process.

“But,” says Krugman, “the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks.”

Banks used “securitisation” to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.

Failure of the new model banking, of an overblown and economically harmful financial sector? In the US administration, the dominant opinion, that of the Treasury department, or for that matter, at President Barack Obama’s council of economic advisers, is: finance and securitisation are here to stay but may be tamed through regulation.