Deleveraging and Financial Intermediation

One consequence of the financial crisis was that our economy had to experience a period of deleveraging.  This period, according to conventional wisdom, constrains the ability of an economy to grow.  I thought it would be interesting to examine the economics of  deleveraging and how the process harms the economy.

In this discussion of deleveraging, I focus on deleveraging that occurs in financial services industry, as that was the primary focus of the deleveraging concerns following the financial crisis.  Nevertheless, the same principles apply to any industry whose participants utilize nonequity capital (e.g. debt, deposits, etc.) to fund its operations.

Financial services companies help savings equal investment in the economy.  Individuals can make direct investments in stocks, bonds, or real estate.  Many, though, don't have the expertise or familiarity with risky investment opportunities to make informed decisions. Financial services companies, also known as financial intermediaries, allow investors to contribute to valuable, yet risky investments, without having to select the investments and, in many cases, accept the risk of the investment.  For example, a bank depositor may earn a small return on his or her deposit, which is guaranteed by the bank and the FDIC.  Meanwhile, the deposit can be used to make a mortgage or small business loan, investments with considerably more risk.  The financial intermediary has expertise in selecting quality investments from among those available, channeling individuals' savings into the most productive investments.  For this service, the intermediary keeps the difference in return between its investment (mortgage or small business loan) and the individual's investment (savings deposit).

The critical contribution that financial intermediaries make to our economy is they allow uninformed, risk adverse individuals to provide capital for risky investments.  Although their investments are risky, financial intermediaries (generally) possess the expertise to select only those investments where the expected return compensates for the risk borne.  When financial intermediaries take lower risk capital and use it in higher risk investments, they are creating financial leverage.  The use of financial leverage requires that the providers of low risk capital have confidence in the financial intermediary to select the appropriate investments and perform appropriate investment monitoring.  

When intermediaries have lost the confidence of those seeking lower risk investments, they can no longer rely on financial leverage.  Deleveraging is the process by which financial intermediaries have to decrease their use of low risk capital sources to make their investments, likely because of a loss of confidence from these low risk investors. Companies can lose investor confidence through a variety of means, including making poor investment selections, experiencing accounting irregularities, or through bad publicity.  During the financial crises, all of these examples were present in some capacity.

When financial leverage is unavailable, the intermediary may be able to raise equity capital to fund its investment opportunities.  As described above, however, many investors don't have the expertise or familiarity to make risky investments in equity.  These investors seek lower risk investments, and when traditional low risk investment alternatives become unacceptable, no investment occurs.  In essence, the individuals with capital to invest don't have the expertise to determine which investments are profitable; during the process of deleveraging they are also unwilling to provide the capital to institutions that do have such expertise.  Profitable investment opportunities are lost as a result, and economic growth suffers.