Economy – Quantitative Finance – General Finance
Scientific paper
2009-04-08
Economy
Quantitative Finance
General Finance
17 pages, 8 colour figures
Scientific paper
Asset backed securities have been extensively criticised for creating a moral hazard in loan issuance by removing any incentive on the lender to ensure that the recipient of such loans could repay them. However the inter-relationship between money and loans within the commercial banking system, also suggests that deeper systemic issues can accompany any form of unlimited commercial bank lending. This paper examines the question of why speculative demand for credit during credit bubbles is not naturally constrained by regulated limits within the banking system on the supply of loans. In particular, we propose an explanation for the current credit crisis, as a fundamental, systemic failure in the system of rules governing the behaviour of the reserve based banking system, which have resulted in the effective removal of central bank control over money and loan supply expansion. This situation has arisen from the presence of two 'bugs' in the underlying regulations controlling the banking system: securitized loans, which allow the sale of loans issued against fractional reserve controlled deposits to entities outside of the commercial banking system; and allowing debt instruments, in particular securitized loans to be part of bank equity capital reserves which are used for the purpose of regulating the total quantity of credit created by the banking system. We argue that the interaction of these two problems has led to unregulated growth in both the money and loan supplies, and to a dangerously destabilising imbalance between total money and loan supply growth, in that total lending from the commercial bank sector has increased at a faster rate than the accompanying money supply growth supporting it.
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