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The father of mortgage-backed securities, unsurprisingly, puts his faith in the power of markets.
Larry Fink last week released his perennially anticipated shareholder letter. This year, he focused on his concerns about global retirement safety against the backdrop of rising life expectancies and inadequate savings.
But he also offered his thoughts on investment market structure. Fink said the advances in the depth and sophistication of US capital and securities markets over the past 40 years had diminished the influence of the banking sector in capital allocation.
The result, says Fink, has been far more dynamism in the economy as traditional banks face prudential constraints — capital requirements, limits to business practices — designed to undercut marginal risk taking. This capital markets primacy, he argues, would create the best opportunity for two ambitious projects, retirement funding and decarbonisation, to be successfully fulfilled.
It is an interesting thesis that has some empirical merit. But markets can be corrupted and are not fail-safe alone. The global financial crisis of 2008 was the result of unprecedented dysfunction and perversion of the mortgage securities market.
Securities markets, in their idealised form, allow investors to hold the risk and duration they want and fluidly trade away those that they do not. The result should be an overall lower cost of capital and thus greater investment. Fink noted that public equities and bonds now accounted for 70 per cent of financing for non-financial companies in the US, the highest proportion in the world. The overall size of securitised instruments well exceeds $10tn.
Fink attributed the US’s faster recovery from the financial crisis relative to Europe to America’s lower dependence on the traditional banking sector. Banks are, by definition, less obsessed with maximising their returns. They function as a place for depositors to safely store their cash and obtain other financial services beyond loans.
But the challenge for capital markets arises when transaction churning and valuations become untethered from underlying fundamental profits and cash flow — a phenomenon that occurs with alarming regularity. When price discovery evaporates, poor capital allocation decisions are not appropriately rewarded.
The sheer size and interconnectedness of capital markets have forced central banks — in 2008, 2020 and 2023 — to become a backstop and buyer of last resort of securities to prop up both the banking sector and the broader economy.
Whatever your preference for banks versus securities markets, accountability for bad actors and those making poor choices must remain paramount.
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