How perverted is our financial system?

FinancialSep 16 ’22 06:33Author: Mark van Harreveld

A Zuidaser moves undisturbed with millions from his Russian employer and makes a fortune from it, a welfare mother is cut from benefits because her mother brings her a bag of groceries every week. ‘Then you have lost your way as a country’, says consultant Simon Lelieveldt. ‘Unfairness is inherent in the design of our financial system’, says Arnoud Boot, professor of financial markets at UvA.

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In the podcast Het Nieuwe Geld, podcast creator Reinjan Prakke goes in search of the flaws in our financial system. And there are quite a few. Furthermore, errors are sometimes amplified by a perverse feedback loop. Illustrative of this dysfunction is financing through loan capital. A piece of cake for those who already have money, for those who don’t have pure fiction.

ATM in the center of Amsterdam
ATM in the center of Amsterdam (ANP / Ton Toemen )

Inherent injustice

‘If you’re rich, it’s easier to get a loan, after all, you have security. This basically promotes wealth inequality. You make money with money. The moment you get a financial system that has an interest in volume, for example in the mortgage market, it reinforces the wealth gap. Inherent unfairness is built into the design of our financial system,’ says Arnoud Boot, professor of financial markets at the University of Amsterdam.

Boot points out that while we have a progressive tax system as a corrective mechanism to smooth out these injustices, it also rewards borrowing money and capital gains (through increased investment or house prices) with large tax benefits. ‘Indebtedness is subsidized.’

Perverse incentive

And what is the perverse incentive in the feedback loop? Home ownership was encouraged, taking on debt to buy a home as well. The result is the dominant paradigm that it is healthy to borrow money to buy a home that also serves as security for the loan in question. According to Boot, this led not only to an enormous growth of the financial system, but also to increasing anonymization. “Security became more important than the investment in the relationship with the customer. The system became anonymous, and the resale of loans became popular’.

Securitization

But why sell a loan on? Because it’s big business; a third of all mortgages are sold on to others. The commonly used technique for this is securitization, where the bank borrows money to make new loans to others. The difference between the relatively low rate that banks pay their lenders and the higher rate they charge the mortgagee, that is the revenue model. “It’s a self-financing loan,” says Boot.

The fact that it is ‘good’ or ‘normal’ to incur debt also has direct consequences for the relationship between debt and equity – both for individuals and companies. For example, how much debt a company can attract has everything to do with the predictability of income. A utility company in quiet rules of the game can be financed up to 80 percent with external capital.

But it could be worse. ‘In a bank you are happy if there is 5 per cent equity on the balance sheet,’ says Professor Boot. “A bank consists of 95 percent of the loan capital. It is not healthy. And if it’s practice, then there can’t be much risk on the asset side.” And Boot hits the nail on the head: Banks are neither enterprising nor innovative. And therefore not future-proofed.

Physical disability

‘You can’t really do business as a bank. Worryingly, they still see themselves as an extension of the government. You know that if things go wrong, the government will come and help you. Then you can get away with just 2 percent equity.’ And then the banking industry has hedged, floating on debt. According to Boot, banks should ask themselves how relevant they will still be in 5 or 10 years. Consider that new players will come with alternatives, that they are not indispensable, and that the government will not save their skin next time.

In case of disability

‘Some of them engage in backroom actions, the regulator and society don’t trust you; you are with people who belong to yesterday’s world; you see new, flexible competition; information technology makes everything possible; you no longer need a bank for money transactions and mortgages; banks have a cumbersome cost structure which is not suitable for the future’.

A lot of debt, little equity and little leeway: In short, the bank is trapped in its own jacket from yesterday.

In this episode of Het Nieuwe Geld, podcaster Reinjan Prakke discusses the flaws in our financial system with:

Simon Lelieveldt: consultant in the financial sector. Simon has previously worked at De Nederlandse Bank and the Dutch Banking Association and in his spare time gives tours of Amsterdam for his Financial Heritage Foundation.

Peter Kuijpers: Expertise Lead Securitization at ING Holland

Arnaud Boot: Professor of Financial Markets at UvA and is involved in WRR

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