While the basics of our financial systems are important, serious issues remain overlooked, writes Con Keating.

This year returning from the calm of the summer doldrums has been depressing rather than invigorating; the main reason has been the disinterment of a lot of old analysis. We have been treated to roundtables and reports on the plumbing of our financial systems; with very little that is new and much that remains unasked, let alone answered.

Long ago, as part of my formation as a banker, I was taught that it was foolish to lend to anyone based on the collateral security offered rather than their debt service capacity. Secured lending could be a conduit for unfair and immoral banking as it raised the possibility of exploiting the debtor in distress through seizure of the collateral asset and its valuation at distress prices. At the very least, a problematic loan carried with it the pure deadweight costs of resolution for one or other party.

There are many who want to see a return to the levels of collateral use seen before the crisis – $10trn versus $6trn recently. The expressed concerns are that there may be a shortage of high quality collateral. This is equivalent to an increase in the broad money supply, at a time when the banks are awash with reserves. It is also symptomatic of a mindset that wants to see an ever- increasing financial sector size; the desirability of which is highly questionable.

There are opposing concerns that would like to see greater “skin in the game” on financial stability grounds. It is obvious that the simplest way to achieve this latter objective is not to increase the collateral security available, but rather to restrict the use of collateral in financial transactions. The idea of collateral use is paradoxical as can be illustrated by consideration of the case of cash collateral and the nonsense that I will lend you $1m if and only if you deposit $1m with me. It seems that collateral security can mask real risks.

The ever larger markets belief is rooted in the idea that liquid active markets are efficient and that prices reveal fundamental value. Nothing could be further from the truth. Liquidity has a cost; if it did not, all assets would be liquid. The premium paid for “benchmark” government bonds makes this obvious – it will be lost to an investor over the life of the bond. Similarly, the prices of equities are inflated by the value of the liquidity option – long-term investors will experience lower yields from these investments. Even the active trading that so many regard as liquidity carries the frictional costs of intermediation – and in aggregate, those costs are lost to investors’ returns.

The information content of market prices is extremely limited; the volatility arising from the endogenous game among market participants makes the extraction of the value signal from this noise impossible for all but very low volatility, high yield instruments. This suggests that the use of market price accounting for long-term institutions is fundamentally misguided, and raises questions over the relevance of their stewardship measurement role. The investment manager may have fulfilled their stewardship duties, but that may tell us very little about meeting longer term or broader objectives.

It is these liquid, active issues that can depart most from fundamental values. Investors really cannot be expected to step in to purchase securities that have fallen or to sell securities that have risen when they cannot identify whether the latest movement is a true signal or merely noise.

There is an issue here for the recent procyclicality analyses; the higher volatility associated with sharp market declines should in fact make long-term investors appear more cautious, as this increase in volatility should raise the expected return they demand of the higher volatility security.

By contrast, the participants in the illiquid sectors are precisely those investors who have conducted their analysis and due diligence and are well informed, which means that their prices do reflect fundamental value. It is unfortunate that the spreads demanded by intermediaries are high and wide, but that reflects their fixed costs base.

The plumbing is important; as is understanding it, but it is only a very small part of our houses.

Con Keating is head of research at BrightonRock Group