You point out that the US government orders banks to pretend that its debt is risk-free. This keeps treasury yields down. But there are more things like this going on. The equity premium and the small-cap premium mean that the farther down an organization is on the power food chain, the higher its borrowing costs. Going down lower, middle-class consumers borrow unsecured at even higher rates, often over 10%, and payday lending means that the cost of capital for the working poor is sky-high. This does not seem like a society in which there’s a meaningful single capital market. It seems like there’s something else interesting and unexplained going on here, which usually doesn’t get accounted for in standard economic models.
At least in public equity markets the size premium is very weak. My team looked at it and decided not to use it as a factor to guide our investing. It’s closely correlated to an illiquidity premia, which I do believe in.
Normally it is uselessly broad, but I wonder if the problem is information. Standard economic models habitually assume perfect, or at least similar, levels of information to simplify things. Some examples of how differences might appear:
My expectation is that as you go down the size scale, less specialized attention is available for managing debts: investment banks spend virtually all of their time and effort on problems of that kind; mid-size corporations that provide a consumer product or service dedicate a team to the problem; small businesses might keep one or two experts on tap; the middle class and working poor alike mostly either forgo expertise or temporarily engage it for the duration of an important transaction (like buying a house).
Is there any kind of reasoning process like “this institution has many other creditors so it is unlikely that I will get nothing in case of default?”
Is there any kind of reasoning process like “this institution has many other creditors so it is unlikely that I will get nothing in case of default?”
Yes, and this sort of behavior creates Too Big To Fail dynamics, which break the connection between long-run financial success and producing things people want more than the cost of production.
A constructive comment:
You point out that the US government orders banks to pretend that its debt is risk-free. This keeps treasury yields down. But there are more things like this going on. The equity premium and the small-cap premium mean that the farther down an organization is on the power food chain, the higher its borrowing costs. Going down lower, middle-class consumers borrow unsecured at even higher rates, often over 10%, and payday lending means that the cost of capital for the working poor is sky-high. This does not seem like a society in which there’s a meaningful single capital market. It seems like there’s something else interesting and unexplained going on here, which usually doesn’t get accounted for in standard economic models.
At least in public equity markets the size premium is very weak. My team looked at it and decided not to use it as a factor to guide our investing. It’s closely correlated to an illiquidity premia, which I do believe in.
Normally it is uselessly broad, but I wonder if the problem is information. Standard economic models habitually assume perfect, or at least similar, levels of information to simplify things. Some examples of how differences might appear:
My expectation is that as you go down the size scale, less specialized attention is available for managing debts: investment banks spend virtually all of their time and effort on problems of that kind; mid-size corporations that provide a consumer product or service dedicate a team to the problem; small businesses might keep one or two experts on tap; the middle class and working poor alike mostly either forgo expertise or temporarily engage it for the duration of an important transaction (like buying a house).
Is there any kind of reasoning process like “this institution has many other creditors so it is unlikely that I will get nothing in case of default?”
Yes, and this sort of behavior creates Too Big To Fail dynamics, which break the connection between long-run financial success and producing things people want more than the cost of production.