The Credit Crisis as a Valorization Problem

Naked Capitalism has a great guest post today which exposes the incentivization process at work in the credit system:

"One source of credit market friction arises from coordination failures among lenders (see for example Gorton and He 2008). In these models, banks are heterogeneous and their behaviour strategic. The individually rational actions of heterogeneous lenders can generate collectively sub-optimal credit provision in both the upswing (a credit boom) and the downswing (a credit crunch). This is a collective action, or co-ordination, problem among banks.

...

"In the face of stiffening competition, banks were increasingly required to keep pace with the returns on equity offered by their rivals – a case not so much of “keeping up with the Joneses” as “keeping up with the Goldmans”."

So we see that the underlying cause of the expansion of credit is the valorization of capital. Not only the simple valorization, but the competition for capital (which I hope to cover soon on its own right) serves as an important ossifying process for companies which cannot necessarily sustain this model:

"As fundamentals improve, high-ability banks are more likely to achieve high returns than low-ability banks. So posting low returns in the boom is particularly damaging to reputation as this constitutes a clearer signal of low ability. This strongly incentivises excessive risk taking to boost short term returns as fundamentals improve."

Not only must banks accrue value for investors at an increasing rate - but they must do so irrespective of the potential risk of such actions. This is parallel to a lot of what has happened in the CDO/MBS securitization bust - even similar enough to indicate a much deeper, generalized problem with the profit-seeking activities of advanced financial institutions.

(Credit to David Aikman, Andrew G Haldane, and Benjamin Nelson; cross posted from VoxEU, Naked Capitalism)
See the Original at VoxEU