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VSE 185-186 - Vie et Sciences de l'entreprise - Crises et Mutations

Banks as creators and Transmitters of Information in Historical Perspective

Abstract :

The current paper argues that commercial banks have used the main developments in information and communication technologies of the last thirty years to specialize in both the creation and transmission of information. The ability to create financial information provides banks with an important strategic advantage that widens as technological innovations allow for an increase in the level of industrial and informational concentration among the larger banks. This concentration process takes place at the expense of the smaller banks that cannot cope with the assimilation and development of the newly introduced information technologies. A descriptive analysis illustrating how this type of structural transformation process has taken place within the evolution of the U.S. commercial banking industry is provided and its relation to the subprime financial crises studied.

Keywords : Commercial banks; ICTs; information creation; Schumpeterian industrial evolution; financial innovation; banking industry; general purpose technologies

Résumé :

Cet article soutient que les banques commerciales ont eu recours aux principaux développements en NTIC des trente dernières années pour se spécialiser à la fois dans la création et la transmission de l’information. La capacité à créer de l’information financière confère aux banques un avantage stratégique important qui s’accroît avec les innovations technologiques permettant une plus grande concentration industrielle et informationnelle des grandes banques. Ce processus de concentration se réalise au détriment des plus petites banques qui ne peuvent faire face à l’assimilation et au développement des technologies de l’information récentes. Cet article présente une analyse descriptive, illustrant comment ce type de processus de transformation structurelle est survenu au sein de l’évolution de l’industrie bancaire états-unienne, et étudie le lien avec la crise des subprimes.

Mots clés : Banque commerciale, NTIC, création de l’information, évolution industrielle à la Schumpeter, innovation financière, secteur bancaire, technologies à usage non spécialisé

Introduction

The motivation for the current paper follows directly from part of the concluding remarks made by Samuel Buell at the end of the lengthy legal process undertaken against Enron after its accounting scandal of 2001. Buell was the lead prosecutor on the Enron case until March 2004 and directly responsible for analyzing and disentangling the complex financial and legal web created through the nineties by the aforementioned energy company, which was de facto behaving as an investment bank. On May 26 2006, after the Enron process sentences were dictated, Buell wrote his last entry on the blog at the Houston Chronicle he had been contributing to and on which he followed the main developments of the Enron process.

“Yesterday was a very good day for the American investor. Enron, unlike all the other recent corporate cases, presented a very important question on day one after its bankruptcy: could financial engineering achieve such a level of arcane complexity that it would be beyond the legal system's capacity to sort it out? The implications of a ‘yes’ answer to this question were quite chilling. The answer yesterday was a decisive ‘no’.”

Ironically, not even two years later the world was going through one of the worst financial engineering based crises of its history. The main argument made by the current paper is that the commercial banking industry, not to speak of investment banks and hedge funds, has been evolving in exactly the direction so much feared by Buell and many others. That is, the creation and monopolization of large quantities of information using financial engineering techniques and instruments.

Interestingly enough, though such an idea is immediately present in the analysis made about the subprime financial crises, its importance for and evolution within the current commercial banking industry has not yet been seriously analyzed. That is, while the concentration process taking place among U.S. commercial banks has being widely documented and analyzed, see Berger (2003) and Jones and Critchfield (2005), the driving forces behind such process remain acknowledged as financial innovations but sorely understudied.

The vital role of information, a purposely vague concept, in both the generation and propagation of the crises is somehow evident among scholars. However, the propagation role that derives from the agency cost known as asymmetric information tends to overshadow the generation one, which is generally soon forgotten.

In order to clarify this point, consider the highly rigorous analysis of the crises made by Charles Calomiris in 2008. In his paper, Calomiris highlights the central role played by information in both, the generation of the crises

“While government encouragement of risky borrowing and loose money played a major role in the current U.S. housing cycle, investors in subprime-related financial claims must share the blame for making ex ante unwise investments, which seem to be best understood as the result of a conflict of interest between asset managers and their clients. In that sense, sponsors of subprime securitizations and the rating agencies – whose unrealistic assumptions about subprime risk were known to investors prior to the run up in subprime investments – were providing the market with investments that asset managers demanded in spite of the obvious understatements of risk in those investments. (p. 20)” and its propagation.

“With respect to the propagation of the shock, much is familiar – the central role of asymmetric information is apparent in adverse selection premia that have affected credit spreads, and in the quantity rationing of money market instruments (p. 20)”.  In addition, he summarized the importance that asymmetric information, the propagation mechanism, has had in the market affected by the corresponding financial shock for the most important distress episodes in U.S. history.

Table 1:
The Diversity of US Financial Shocks

 

Banking Crisis

Real Estate Related

Importance of Asymmetric Information in Relevant Market

Severity of Financial Shock Relative to size of Economy

Panic of 1893

Yes

Partly

High

Low

Panic of 1907

Yes

No

High

Low

Agriculture Crisis 1920-1930

Yes

Yes

Low

High

Financial Crisis of 1929

No

No

Low

High

Banking Crisis 1931-1933

Yes

Partly

Occasional, mainly regional

High

Penn Central Bank 1970

No

No

High

Low

Agricultural Crisis

Early 1980s

Yes

Yes

Low

Moderate

Bank and Savings and Loan Crisis

1980-1991

Yes

Yes

Varied

High

Financial Crisis of 1987

No

No

Low

High

Dot Com Financing

2001

No

No

Low

High

Financial Crisis 2008

Yes

Yes

High

High


Source: Calomiris 2008.

Clearly, and even though information has remained a mildly important variable during the financial shocks taking place after 1970, the subprime financial crises displays a renewed dependence on information asymmetries.

However, a highly important and obvious question remains. If, as Calomiris states, the “unrealistic assumptions about subprime risk were known to investors prior to the run up in subprime investments” and managers were demanding investments “in spite of the obvious understatements of risk in those investments”, then, the question is how could the subprime financial crises happen

That is, while information asymmetries were of high importance at propagating the shock, what was their importance in generating it. Based on the statement of Calomiris the answer should include the word essential in it and stand in sharp contrast to the inability of academics and regulators to realize what was apparently obvious.

Before proceeding, we should consider the generation process of the money multiplier. Commercial banks do not really keep money in their vaults, and were people to realize about the potential instability of their deposits, they would probably run on the bank. Therefore, banks have had to specialize in the obvious task of making their depositors forget about this fact by dragging all financial related information regarding the use of deposits away from them. That is, banks have specialized in information processing and their main objective has been the creation of as much information as possible so that only those market players with the technology and the resources to access and control it could operate within the information-based financial system they have created.

The main objective of the current paper is to verify this idea by analyzing the evolution of the U.S. commercial banking industry through the last twenty years. In this regard, note that the current financial crises spread through different technologically-generated information-based financial markets, that is, from the subprime mortgage market to securitization products and, finally, to credit markets. Clearly, the first two are information markets generated thanks to the innovations in information technology developed through the last decades of the 20th century. Information is taken away from the standard credit markets and transmitted in larger disaggregated quantities to secondary markets. Therefore, as Goldstein and Pauzner (2005) remark, “in many cases, the assumption that investors observe noisy signals is more realistic than the assumption that they all share the very same information and opinions”.

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