Understanding Financial Institutions

Imagining a course for dummies/techies

With DeFi, anyone in the world can lend, borrow, send, or trade blockchain-based assets using easily downloadable wallets without having to use a bank or broker. If they wish, they can explore even more advanced financial activities —  leveraged trading, structured products, synthetic assets, insurance underwriting, market making —  while always retaining complete control over their assets.  

—Marvin Ammori

Marvin Ammori understands more than I ever will about decentralized finance (DeFi). Indeed, there are thousands of young techies who understand DeFi better than I do.

But I bet that in order for DeFi to work, you need an understanding of financial institutions in addition to an understanding of blockchain and the layers that have been added to it. I don’t think that young techies understand financial institutions as well as I do. And I think I have a better chance of explaining my knowledge of financial institutions to young techies than they have of explaining DeFi technology to me. So I hereby offer to teach a course in financial institutions.

As a teaser, let me offer a lesson on the difference between the formal sector and the informal sector.

The formal sector and the informal sector

The formal sector of the economy consists of transactions that the government will help to enforce. The informal sector of the economy consists of transactions that the government will not enforce—the government might even attempt to interfere with such transactions.

We can think of financial institutions as lying on a continuum somewhere between informal and formal. At the formal end of the spectrum, institutions are adjacent to the government. At the informal end of the spectrum, institutions are adjacent to criminal activity.

Some institutions, such as commercial banks in the United States, are very much in the formal sector. The government backs them with deposit insurance, and it sometimes goes beyond that to ensure that troubled banks are either merged into other banks or are bailed out altogether, rather than be put through bankruptcy. The government regulates banks carefully, although not always effectively.

Other institutions, such as payday lenders, are closer to the informal sector. To my knowledge, the government has never stepped in to help a troubled payday lender stay in business.

Prior to the financial crisis of 2008, a phenomenon that became known as “shadow banking” emerged, particularly around trading mortgage-backed securities. Shadow banking was not adjacent to the government, but it was sufficiently entangled with major commercial banks that some of shadow banking was covered by the bailouts that the government undertook in 2008 .

In addition to being adjacent to the government, the formal sector enjoys some protection from competition. Protection from competition raises profit margins.

With high profit margins, protected institutions have what we call “franchise value.” Franchise value gives managers of these institutions an incentive not to take chances. The more valuable your franchise, the more you stand to lose by taking an ill-considered risk.

But high profit margins create an opportunity for competitors to step in. These competitors often come from the informal sector.

For example, as of about 2000, Freddie Mac and Fannie Mae had very high franchise value. They were the only successful issuers of mortgage-backed securities. But around that time, innovations in the market made it possible for private issuers of mortgage-backed securities to begin to compete with Freddie and Fannie. This eroded the franchise value of Freddie and Fannie, reducing their incentive to avoid taking risk. So Freddie and Fannie took on more risk, venturing into the market for shakier mortgage loans. In 2008 they collapsed, losing their franchises as the government took them under “conservatorship.”

In short, institutions that are distinct from the formal sector can reach customers that the formal sector will not serve. Informal institutions can compete away some of the excess profits of the formal sector. But an advanced economy still depends heavily on the formal sector. The benefits provided by letting the informal sector expand should be weighed against the costs of undermining the formal sector.

The Reading List

For the course in financial institutions, I have in mind something like the seminar courses I took in college, where each week a different student was responsible for summarizing the readings in a paper. Off the top of my head, here are the readings for the course.

Niall Ferguson, The Cash Nexus. Explains the inevitable connection between banking and government.

Hernando de Soto, The Mystery of Capital. Explains the huge benefits of moving property from the informal sector to the formal sector.

Arnold Kling, Specialization and Trade. Explains how financial institutions complement the nonfinancial sector.

Marcia Stigum’s The Money Market. Explains repurchase agreements along with other important real-world financial instruments that your economics course did not cover.

George Goodman, aka ‘Adam Smith’ The Money Game. Is the market rational? The participants certainly are not.

Charles Kindleberger, Manias, Panics, and Crashes. Sudden shifts in wealth can lead to “Minsky moments.”

Michael Lewis, Liar’s Poker. Ego and machismo swagger down Wall Street.

Bethany McLean and Joe Nocera, All the Devils are Here. But eventually, if you have large financial ambitions, you come to Washington to lobby.

Steven Pizzo, Inside Job. In the 1970s, the institutions known as Savings and Loans saw their franchise value eroded. This book is about how they responded.

Anyone interested in taking the course?