Questions:
1. Why did banks shift from originate-to-hold models to originate-to-distribute models in terms of giving loans? How did this affect the relative importance of underwriting versus credit ratings and credit scores? See post on Rise of Originate to Distribute and also Bord and Santos
Answer: Previously banks used to make loans with the intention of holding them to maturity, as opposed to selling them to other financial institutions and/or investors, this system termed as originate-to-hold model. But with the period of time banks started increasingly to distribute the loans they originate and shifted to originate-to-distribute models. With this change, banks limited the growth of their balance sheets but maintained an important role in the origination of corporate loans, and in the process contributed to the growth of nonbank financial intermediaries.
Before the financial crisis of 2007, the significant growth of the market for collateralized loan obligations (CLOs) reasoned for an important increase in the demand for corporate loans, giving banks an opportunity to distribute larger portions of the loans they originated. This shift reduced the relative importance of underwriting in such a way that now banks started to disregard the creditworthiness of the debtor as now they can give the credit to such client by charging high interest rate who is with low credit score. Meaning that clients who have low credit rating with high risk of default, banks distribute debt instruments to them by charging high rate of interest so that it can compensate against default risk. With this behavior in aggregate, banks took financial sector at brink of crises.
2. Explain the rise of shadow banks as part of the trends described in 1 above. How did this created pressures for de-regulation of regular investment banks, and how shadow banks made Glass-Steagall ineffective. Also explain how Minsky's financial fragility predicts the rise of shadow banks.
Answer: After the adoption of origin to distribute model, Banks and other financial institutions started to extent the loans to the borrowers and packaged these loans into securities like CDOs, ABSs, Asset backed commercial paper (ABCP), and structured investment vehicles. After that, these packaged securities then sliced into various tranches and distributed in such way that high rated trances went to more risk averse investors while low rated trances went to those investors who were risk lovers. This way created pressures for deregulation of investment banks. Glass steagall act was consisting of four provisions which tend to regulate and separate the commercial and investment banks. But by adoption of origin to distribute model and emerging of shadow banking via this undertaking, shadow banks made glass steagall act almost dead as they were able to trade non governmental securities for customers, were investing in non-investment grade securities for themselves, completely undermined underwriting rules and also affiliated with companies who were involved in such proponents.
3. List some of the regulations required, in light of Minsky's analysis, to reform the financial system, so as to prevent future crises. Explain the policies and how they would act to reduce fragility. Have such policies been undertaken in reality?
Answer: Minsky proposed some reforms for the financial system for the prevention of future crises. In following we will discuss some of these.
According to Minsky, there should be such financial structure which is Conducive to economic development and should promote welfare.
1. There should be smooth payment system; it should not be very complex. Further it should smooth out the difficulties faced due to imbalances in cash flows and should provide short term loans in this particular situation. Further short term loans can be provided as commercial loans to the firms by banks, consumer loans: by issuing credit card etc, there should some long term student loans provided by banks instead of government but should guaranteed by the government.
2. There should be secure payment system. For securing payment system, first proposal was that FDIC should guarantee that all bank deposits trade at par, deposits or claims on the bank should be have equal value to the amount of money that is present in the account. Another alternative that can secure payment system is introducing postal saving system at the place of banking saving system and third option is that restrict banks to the narrow banking so that they could not issue loans and should be allowed to have deposits only.
L17 Why Minsky Matters Ch 7 Reforming the Financial Sector - Video Lecture:Wray Ch 7 Minsky's Views on How to reform the Financial Sector.