Financial firms are not only one of the major sectors in the whole economy. They are in a strategic position that propel the direction of economy through its influence on credit. Today, financial intermediaries not only finance business investment but also consumption. That means the pullback of credit or loans from financial sector will have double effects on economy.
In old days, banks used to be careful in watching the creditworthiness of industrial and business firms to make sure that they will pay back their loans. In modern finance world, banks need not to worry about the underlying financial strength of firms too much. They underwrite businesses and sell stocks, bonds and all kinds of different financial instruments directly back to creditors while extracting fees by servicing as intermediaries. Now they are in true sense of being intermediaries that the only goal is to achieve higher rate of return for its own shareholders. As they underwrite more and more businesses, they also use their retail channels to help the business sectors to sell these financial securities. In return, they extract fees from servicing both borrowers and lenders.
Financial firms and even the financial branch of big corporations has also been emerged to be major players in providing consumer credit during the last decades. The underlying consumption is that banks can diversify the credit risk of individuals by underwriting a huge pools of loans. They underwrite these pools of consumer debts into financial instruments and sell them back to the creditors who are willing to hold these securities. If banks or financial institutions are successful in marketing these securities and get ride of these loans and securities from their balance sheet, they will successfully transmit risk from borrowers to creditors. The only concern is that when the financial market are in turmoil, the financial intermediaries' fee business will be significantly reduced due to the lack of demand from both borrowers and creditors.
Financial instruments are in essence debts. We live in a society saturated with all different kinds of securities which assumes to meet the different needs of individual investors. However, the essence of all these securities are the same. Stocks and bonds are essentially the claims to firms' future streams of income and they vary in terms of priorities and forms of payment.We are a nation that saturated with financial advisers or investment advises that helps to manage your money. In reality, what they really want to sell are loads of debt to you. Whether you will earn the rate of return expected from these securities depends on the underlying business or consumers' ability to generate enough cash flow to pay back their debt obligations. The return of securities depends on the expected future profitability of business and expected future wage income of consumers.
There is an over-grown financial instruments (in other words debts) comparing to real productive economy. If the growth of financial products is greater than the growth of GDP (real economy), it is usually a sign of accelerating built up of debt . Productivity growth has been snagging for the last two decades. The return on securities including both stocks and bonds has been far greater than the growth of productivity and the growth of GDP. The assets of the economy including pension funds, mutual funds has been increased dramatically during the last decades while all the assets are in essence debts from other side of coin. Modern finance makes money circulates faster than ever and creates money ever faster than before out of control of banking regulatory system. In credit boom situations, accelerating amount of assets has been invested in securities which drives the rate of return higher than real productivity gain of the whole economy. Gradually, the optimistic outlook acts as a self-confirming evidence and takes on the life of its own to reach an even higher level of indebtedness for both business and consumers.
The credit boom circuit will break when it's time for consumers and business to pay back its interest and principle obligations. Some time it may starts as self-fulfilling prophecy that more and more investors start to worry about debt level. Some time it starts with the failure of business and individuals to pay back their loans. When pessimistic sentiments penetrate the market, the two forces reinforce each other and start a strong momentum to drive economy downward. That's what we saw during the last two years. Creditors pull back their investments quickly. Without reducing credit, business and consumers has been squeezed and the economy went nosedive.
Globalization also adds up complications to existing problems. Export of US financial assets has been one of the most important businesses that global financial institutions did. US has run trade deficit with the rest of the world for decades. The sales of financial instruments has been increased dramatically during the last five years.
The same argument can be made to domestic market as well. Financial securities has been greatly oversold which created the credit driven boom economy for a very long period of time. It's going to take a long long time to wait for consumers to build up savings for consumption if we want to reduce instabilities built in by financial institutions today.
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6 years ago