Monday, 31 August 2020

Thought Experiment: How do you Price the Office Parlour Palm?

Posted by Martin Cohen
Here's one of a collection of short puzzles that might be considered an A-Z of the tricks of high finance: Not so much 'P is for Parlour Palm' though as 'C is for Cheap Collateral'.

This is the idea that if a bank agrees to loan the office parlour palm to the next door bank for a million dollars, and in return to rent their aspidistra for a million dollars, they both can update their asset sheets accordingly!

Now that's magic. But it was also the basis of the B for Bubble that brought down most of the world's banking system in 2008!

Of course, banks don't do silly stuff like buy each others' pot plants. But they do buy each others' packaged securities. And for many years, these packages became more and more complex, and thus more and more about buyer and seller agreeing on what mysterious qualities made the deal realistic. We know where that ended up: with thousands of dodgy loans to people who had no income or maybe had even died being bundled up and sold as top quality assets. Banks are plagued by problems with so-called ‘ghost’ collateral that disappears or is pledged to several lenders at the same time! After the crisis, the European Central Bank looked at the use of such devices and in a discussion paper wrote:

"the use of collateral is neither a sufficient nor a necessary condition for financial stability."*

The logicians could not have put it better!


https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2107.en.pdf

3 comments:

Keith said...

I’d like to take a different approach to this topic about the banking world and its practice of collaterising exchanges, to pull apart the quote drawn from the ECB report. . .

I suppose that in the head-scratching world of ‘ghost collateral’, juxtaposing the arguably ^mutually canceling^ terms ‘insufficient’ and ‘unnecessary’ regarding the role of collateral in financial stability doesn’t surprise me, even if it perplexes me.

If collateral is not a ‘necessary condition’, then surely it cannot be judged simultaneously as not a ‘sufficient condition’. All sounds a tad Orwellian in the report's strained use of language. For logical consistency, might the realities of the banking world have to be one or the other? Not both?

Was the report, in the quote pulled, angling for banks to have a handy escape hatch no matter which interpretation they opted for: that is, whether collateral is either insufficient ^or^ unnecessary for financial stability?

Either interpretation seems to give stakeholders a lot of latitude in calling ‘the right play’, where accountability for decisions by banking industry powerbrokers is comfortably minimised. No wonder there still are collateral risks to our banking’s and economies’ soundness, albeit mostly out of the public's eye — ‘office parlour palms’ aside.

Martin Cohen said...

I think the idea behind the quote is to reject the whole 'frame' that the question of financial stability was being put in. That is to say, rejecting the assumptions about what gives something a monetary value. However, we rely on much weaker assumptions all the time! Particularly, in terms of the values of houses, hence the 'sub-prime crisis' and all that. I think the thought experiment is intriguing and useful as it highlights the circular, reciprocal nature of valuations - and trust more generally.

Thomas Scarborough said...

It reminds me rather of the kula ring, the continual exchange of ritual objects in pre-modern societies. Malinowski considered the practice 'functionally necessary' for social stability.

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