Expected return

Regulatory Discretion and Asset Prices

The Federal Reserve’s annual stress test is the de facto capital planning regime for the largest U.S. banks. Not surprisingly, it comes under frequent attack from bank CEOs who argue, as Jamie Dimon recently did, that “banks have too much capital…and more of that capital can be safely used to finance the economy” (see page 22 here). From their perspective, this makes sense. Bank shareholders, who the CEOs represent, benefit from the upside in good times, but do not bear the full costs when the financial system falters. As readers of this blog know, we’ve argued frequently that capital requirements should be raised further in order to better align banks’ private incentives with those of society (see, for example, here and here).

A more compelling criticism of central bank stress tests focuses on their discretionary character. To the extent feasible, central banks should minimize their interference in the allocation of resources by private intermediaries, allowing them to direct lending to those projects deemed to be the most productive.

But the painful lessons that have come from large asset price swings and high concentrations of risk provide a strong case for the kind of limited discretion that the Fed uses in formulating its stress tests. This blog post highlights why it makes sense for regulators to use this year's stress test exercise to learn how well the largest U.S. intermediaries would fare if the recent commercial real estate price boom were to turn into a bust....

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The even cloudier future of peer-to-peer lending

In early 2015, we expressed skepticism about the prospects for peer-to-peer (P2P) lending. Like other efforts to slash financial transactions costs (think “block chain”), P2P was all the rage. The notion was that the lenders and borrowers could cut out the middle man, “disrupting” traditional finance.

For that to work, for P2P investors to get an attractive risk-adjusted return, it would have to embody a technology that can screen and monitor borrowers at a lower cost than do existing intermediaries in the long-established sector of consumer credit. That seemed especially doubtful in a competitive industry like credit card lending, which is what P2P lending often turns out to be...


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The cloudy future of peer-to-peer lending

Peer-to-peer (P2P) lending is all the rage. The idea is that individuals can bypass traditional financial intermediaries and borrow directly from investors at lower cost (or obtain credit that banks would not provide). Improving the lot of borrowers would be great if it works. But the key question is whether lenders can efficiently screen and monitor borrowers to get an attractive risk-adjusted return on their investment. In effect, individuals would be beating the technology that traditional lenders use. It’s far too early to tell, but there is plenty of scope for skepticism...

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