Open assessment on loan market monitoring system

Open assessment on loan market monitoring system explores possible mechanisms to monitor the loan market in an efficient way to prevent future loan market crises.

Scope

Purpose

The purpose is to identify the critical issues related to loan market supervision. The main questions are

What is an effective model for loan market such that it describes the critical elements of the loaning and borrowing acts?
Who are the critical players in the model?
What are the critical issues that determine the well-being of the loan market?
What are the indicators of the critical issues such that they can be effectively and reliably monitored?

Boundaries

This is a theoretical assessment that should be applicable anywhere in time and space where people loan and borrow money.

Scenarios

None defined

Indended users

Authorities in the loan market
Anyone in the loan market
Anyone interested

Participants

This is an open assessment, so anyone who accepts the rules of open assessment is allowed to participate.
This is a potential assessment that is not actually performed. If enough assessors show up, the assessment will actually be performed.

Definition

The loan market is hugely complex, interactive, scalable, dynamic, and even chaotic. However, it can be described as a system that consists of simple atoms that interact with each other, just like atoms or molecules in a test tube.

A "loan atom" consists of the following parts:

The borrower
The loaner
The loan decision

The loaner decides to give money (amount M) to the borrower at time t₀. The borrower promises to pay the loan back according to a pay-back plan M_t,r (the plan has a time dimension t and an interest rate r). The difference U = M_t,r - M is the nominal profit (or the nominal utility) that the lender gets. On the other hand, there is the risk that the borrower cannot pay (a part of) the loan, and a credit loss L occurs, the actual profit being U - L.

Ideally, the lender compensates L by demanding a higher U from the borrower. The reason of the current financial crisis is that on the scale of the whole US financial business, L has been much higher than the market anticipated. Therefore, U has been set to a lower level than what would have been done if the true value of L had been known.

Another problem in the current system is that after the mistakes have been discovered, there is no-one to blame. It is clear to everyone that mistakes indeed were made, but the adverse effects just disperse in the financial sector. There is a poor correlation between the size of the mistake an actor made and the loss the actor faces.

Result

What is an effective model for loan market such that describes the critical elements of the loan giving and taking acts?

The model consists of atoms of the actual loan decisions. Each loan decision has the same basic structure. (See below.) The possible administrative actions and indicators should focus on the loan atom, not on the complex system consisting of atoms.

Who are the critical players in the model?

The loaner and the borrower. The loaner is the more important player, because the borrower only applies for money, but the loaner makes the actual loan decision. Thus, administrative actions and indicators should focus on the loaner.

What are the critical issues that determine the well-being of the loan market?

The loan amount M
The nominal profit U when the decision was made
The initial expected profit U - L_t0 (where L_t0 is the estimate of the loss of the loan at the time of loan decision)
The current expected profit U - L_t (where L_t is the current estimate of the loss of loans that have not yet been paid back)
The actual profit U - L (which is known afterward).

What are the indicators of the critical issues such that they can be effectively and reliably monitored?

All of the critical issues mentioned above can easily be monitored if wanted. This can and should be done at individual loaner level. Individual is the person who is personally responsible for all his/her decisions as loaner. Depending on the culture in the company, the responsibility can be centralised or decentralised in the organisation, but in every case there is exactly one person who is reponsible for each loan decision.

Loan market monitoring system

This is a hypothetical system for monitoring the loan market and its well-being. It also enables hindsight when problems have occured.

There must be a law that for each loan decision, the following information must be recorded: the identity of the loaner, the loan amount M, the nominal profit U when the decision was made, the current expected profit U - L_t, and the actual profit U - L. These indicators must be calculated as cumulative amounts at the individual loaner level. This information must be made publicly available regularly, e.g. four times per year.

When other loaners want to evaluate the credibility of a loaner as borrower, they just need to look at his/her loan-making decisions to see whether there is a mismatch between the expected and realised profit. The difference tells a lot about the pay-back capability.

If a loaner wants to sell a loan, the indicators of the loan must be made available to the loan buyer. The critical indicator is the current expected profit U - L_t. This makes the situation more transparent to the buyer. It also makes it easier to the auditors to evaluate the situation afterward. The final, realised loss L is always calculated to the cumulative loss of the original loaner even if the loan is sold. If the actual L turns out to be much different than the original loaner predicted, this will affect his/her reputation as loaner. Thus, although the original owner may sell the loan and thus get rid of the financial responsibilities related it, he/she cannot get rid of the evaluation of the original loan decision and the impact of this evaluation to the reputation.

These indicators are available to the auditors at individual loan decision level. And to the police as well, if illegal actions are suspected.