



The Bank for International Settlements (BIS) hosts an annual conference that brings together central bank governors, leading academics and former public officials to exchange views.

At the 13th Annual Conference a research paper was presented by Bengt Holmstrom of the MIT titled Understanding the role of debt in the financial system on the mechanisms of the financial market in connection with the 2007-now crash.

The paper includes the following fascinating statements:

[..] But it is hard to believe that investment bankers would be colluding to defraud investors [by issuing opaque securities].

Probably as hard to believe as that investment bankers would be colluding to defraud investors by manipulating the London interbank offered rate (they did). Or by manipulating foreign exchange rates (they did). Or by manipulating the ISDAfix Interest Rate Derivative Index (they did).



Or that a publicly held, international corporation would massively invest in the expansion of the Auschwitz concentration camp (they did) .

An economic reality is that white-collar crime has a higher Return on Investment than most legal activities, so the imperative of increasing profits enforces criminal behaviour, specially when the the rate of detection+prosecution+conviction is near zero.

And shortly after:

[..] But it equally hard to believe that hard-nosed profit-hungry investment bankers and traders would be ignorant out of ignorance.

The crash did not harm the profits of aforementioned bankers and traders at all. So there is no incentive to smarten up (Holmstrom is supposed to be an expert on incentives).

Invoking the empirical sucess of the EMH [Efficient Market Hypothesis] (in a variant they call relative EMH), Gilson and Kraakman (2014) among others have advocated [...]

What the crash of 2007 very empirically proved was the failure of the Efficient Market Hypothesis. If prices reflect all available information, and still fluctuate by more than 50 percent in a single day, then that reflecting property is worthless.

That leading academics show such naïvité at the motivations of criminals and cling to unrealistic assumptions is just depressing.

The paper goes on to show that collateral-backed debt is an extremely stable investment, and information-insensitive (because 1. it is backed and 2. the debtor might recover before the debt contract ends). Having more transparent collateralisation, Holstrom argues, would affect the traders' belief system as to the value of the lending bank, thereby endangering the stability of banks, which is posited as a common good. In other words:

market participants are not rational, they have “belief systems” market efficiency is bad for market participants market efficiency is not a necessity, it can easily be avoided by publishing less information

This reasoning could be called anti-circular, and I'd suspect that there is no other field of academics where conclusions negate the premises used to draw the conclusions.

Ernst-Ludwig von Thadden's attached commentary at the end of the paper shows some hope, as he points out the aspect of time (mostly ignored by economists, because differential equations are just too hard) in the handling of debt, i.e., debt based vehicles rely on a rollover of short-term debt over time. So they're not so risk-free over a longer term.