1
The Introduction of a Private
Credit Platform:
An analysis on why the implementation of a public private credit
platform would be an improvement for private credit markets
By: Jules Nusteling Master thesis 10763546
Supervisor: Annette Freyberg-Inan Second Reader: Daniel Mügge Word count: 23,436
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Abstract:
This thesis introduces a private credit platform and argues that this is an improvement for contemporary private credit markets. It analyses how private credit has an important function in the stability of the financial system, and establishes that private credit can function as a mechanism for structural injustice. It is argued in this thesis that these issues surrounding private credit can be solved by the implementation of a private credit platform. The platform functions as a broker for private credit, is tasked with performing due diligence checks, offers improved financial advice and reports the current situation to the government. These functions of the platform will make sure that the issues caused by private credit on financial stability and structural injustice will be reduced.
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Acknowledgements
I want to thank Annette Freyberg-Inan for her superb supervision during the writing of this thesis. She would always point me in the right direction. I also want to thank Mateusz Zakrzewski for providing me with interesting insights on my thought process during our frequent meetings. Last but not least, I want to thank the alphabet. Without these three, I
4 Table of Content
Abstract: ... 2
Chapter I: Introduction ... 5
Chapter II: The influence of Private Credit on the Financial Crisis of 2008 ... 8
2.1 The Crisis of 2008 ... 8
2.2 The impact of Securitization on the Financial Market ... 8
2.3 Mortgages as the Cornerstone ... 10
2.4 From Boom to Bubble, from Bubble to Bust ... 14
2.5 The role of Private Credit ... 15
Chapter III: The implications of Credit for Society ... 16
3.1 Credit as a Mechanism for Injustice ... 16
3.2 On Freedom and Injustice ... 17
3.2.1 Freedom ... 17
3.2.2 Structural Injustice ... 20
3.3 The Necessity of Credit ... 21
3.4 The Implications of Private Credit for Structural Injustice ... 25
3.5 The Liberating Function of Credit... 28
Chapter IV: The Introduction of the Private Credit Platform ... 30
4.1 A Partial Solution for the Information Problem in Private Credit Markets ... 30
4.2 The Need of the Development of a Credit Platform ... 30
4.3 Developing a Foundation ... 33
4.4 The Functioning of the Private Credit Platform ... 37
4.5 Regulation of the Private Credit Platform ... 41
4.6 Prospected Implications of the Private Credit Platform ... 43
Chapter V: Conclusion ... 50
5.1 Summary ... 50
5.2 Further Recommendations ... 51
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Chapter I: Introduction
Credit has an important role in societies that rely on the principle of private property (Meyer 2018: 305). This thesis introduces the idea of a private credit platform. It argues that the development of a government-owned private credit platform would be an improvement for private credit markets. A private credit platform is a government-owned institution of which the functioning will be explained in this thesis.
It is important to first identify why private credit markets are in need of improvement. Historically, credit has become more and more embedded in capitalist society (Streeck 2015: 38). States moved away from their functions as welfare states, which turned some of the the reliance on public debt into a reliance on private credit. Consumerism, driven by the expansionary logic of capitalism, further contributed to the rise of private credit. The financial crisis of 2008 showed that the dependence on credit meant that the financial system as a whole became fragile. It demonstrated how the embeddedness of private credit in society has negative consequences for financial risk. But private credit can not only be problematic for the stability of the financial system. As credit can be understood as a necessity in society, it becomes evident that it should be equally accessible, and no individuals should be overcharged on credit (Herzog 2018: 411). However, this is not the case. Due to the important role of credit in society, it becomes important that private credit does not function as a mechanism for maintaining or increasing structural injustice. This thesis argues in favour of developing a public private credit platform that solves certain issues regarding the impact of private credit on financial stability and structural injustice.
The second chapter of this thesis elaborates on the role of private credit in the development of the financial crisis of 2008. The financial crisis is used as an example to show how private credit influences the stability of the financial markets. This counts for national and international financial markets. The third chapter focuses on the normative issues of private credit. This chapter argues that credit is necessary for society. It also explains how this can make private credit affect different types of freedom and become a mechanism for structural injustice. The chapter starts off by explaining the concepts of freedom and injustice, as this is necessary in order to understand how credit can affect freedom and function as a mechanism for structural injustice. The chapter argues that there are three factors of credit that support injustice: overly expensive credit, the lack of fully informed consent on loans, and the issues surrounding the overall accessibility of credit for certain groups in society. The second and third are arguments in favour of developing a private credit platform. The fourth chapter focuses on how this platform functions and how it provides solutions for the issues raised in chapters two and three.
6 The private credit platform has several functions in order to solve the issues of the private credit market. First I will explain that the platform adopts certain institutional ideas from the concept of central counter parties. It adapts the idea of novation in a certain way, so that there is a possibility for individuals in society to attain credit anonymously. The next step is to explain the four functions of the private credit platform. The platform functions as a broker between consumers and creditors, provides improved financial advice to potential consumers in order to increase the levels of financial education in society, performs due diligence checks on costumers, and is tasked with providing information on the situation of the private credit market to the government. These functions of the platform assure that the overall freedom of individuals regarding private credit is improved, that the effect of private credit on structural injustice is diminished and that the financial system becomes more resilient against financial shocks. It generates a situation in which it becomes more difficult for banks to misjudge the credit rating of individuals, where individuals have the possibility to make better choices due to there being more information available to them and an overall lower cost of private credit for consumers. This is why the implementation of the private credit platform would be an improvement for private credit markets.
To provide arguments in favour of implementing the platform, it is first important to develop an understanding of the role of credit in society as well as in the financial system. The second chapter is an analysis of how the financial crisis of 2008 developed, and what the role of private credit was in this development. This thesis used a literature review in order to establish the role of private credit. For the third chapter this thesis also makes use of a literature review in order to define the concepts of freedom and injustice and to determine why credit is necessary in modern contemporary capitalist society.
I also utilise a literature review in order to determine why credit can function as a mechanism for structural injustice. Both of these chapters function as arguments for the statement that private credit markets need to be improved. These arguments are both practical and normative in nature. The next step is to develop the envisioned platform. It is important to note here that the development of the platform uses aspects that are functional in other areas of the financial system. This is analysed through a literature review on financial institutions, focused mainly on central counter parties. Due to this being an attempt at innovating the private credit markets, the method of this thesis might seem unconventional. The start of developing the platform was to look at the problems raised in the second and third chapter and think of solutions to them. The next step was to find realistic solutions to these problems. This thesis is non-ideal theoretical work. Non-ideal theory focuses on comparing and developing institutions in order to come closer to a fully just society. This thesis does not aim to generate an ideal situation that is impossible to realise in the ‘real world’. However, for non-ideal theory to function, it is
7 necessary that it is built on principles of ideal theory (Robeyns 2008: 314). Therefore, parts of the third chapter employ ideal theory. This offers the opportunity to understand what the issues are, and offers insights on the possibilities to solve these issues. This is what motivated the creation of the private credit platform. This thesis argues that the implementation of this platform solves parts of both the practical and normative issues surrounding private credit markets.
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Chapter II: The influence of Private Credit on the Financial
Crisis of 2008
2.1 The Crisis of 2008
This chapter will focus on the contemporary situation of private credit markets. It examines the flaws and benefits of the current system, and tries to determine how prone this system is to crisis. In order to establish the way in which the system is prone to crisis it becomes important to look into what happened in 2008 with the financial crisis. This chapter will first summarize what went wrong prior to 2008 in the private credit market system in order to establish which flaws are still in place. The second step is to look at the system and how it functions nowadays. Here it becomes important to focus on changes that have been implemented since the global financial crisis of 2008.
One could write several books on what went wrong leading up to the financial crisis of 2008. The problem with determining exactly what went wrong is that one could start almost anywhere in modern history in order to establish where we started moving towards the global financial disaster of 2008. This thesis focuses on the problems caused by the private lending in the USA, determining the role mortgages played in the build-up towards the financial crisis. This thesis does not state that this is the sole reason of the financial crisis, but it acknowledges that handling all factors of the financial crisis is simply too large of a task for a single master thesis. This chapter does not try to establish what the crucial factor for the crisis of 2008 was, but it uses the build-up to the financial crisis to establish certain problems with private credit markets. It is important to keep in mind that no events happen in a vacuum, and that the financial crisis was a complex event that only could happen due to the high level of interconnectedness of global actors in the financial world. While still highly relevant for the future of the global economy, this thesis does not focus on the problems surrounding contagion. It analyses what happened in the United States in order to develop more understanding of the risks of private credit markets.
2.2 The impact of Securitization on the Financial Market
In order to establish the flaws of private credit markets it is important to focus on the decennium prior to the financial crisis. There was a notion on economic growth that the sky was the limit, with the focus lying on unbridled economic growth. In our search to explain what exactly went wrong it is important to find a starting point building up to the crisis. The search begins in the early 2000’s. This period was marked by the aftermath of the internet bubble, the attacks on the World Trade Centre on 9/11 2001, and the wars that ensued by the United States in9 Afghanistan and Iraq (Zandi 2009: 9). These events had caused the stock markets, a prominent part of the American economy, to plummet (ibid). In response the Federal Reserve of the United States lowered their interest rates. The lowering of the interest rate might not look like a normal reaction towards declining rates of stocks (idem: 10). The risk is that it can spark high levels of inflation. This could be problematic option for policymakers, but there was another new international player on the market, China.
China became a member of the World Trade Organisation on the 11th of December in 2001. Entry to the WTO provided opportunities for China on the international market. Due to the principle of non-discrimination of the WTO, becoming a member dissolved several trade barriers for China. The vast mainland of China had now become able to export their products on a large scale. This made China a big competitor, as their cheap products flooded the international market, meaning the prices fell all around. When prices are declining inflation is not as much of a problem. Another important factor of the rise of China was the increase of demand for oil. As a big exporter of oil a lot of currency flooded towards the United States. This pushed up the trade deficit of the United States, while where a large amount of dollars flowed towards countries in the Middle East, Russia and China. These large quantities of dollars were then in turn used to invest. At the time the US economy was the biggest and most stable economy in the world. With the low interest rates of the Federal Reserve and the increasing amount of foreign demand for investing, foreign investors surged their investments towards the United States (Zandi 2009: 9). This gave the opportunity for huge financial innovations. The bankers and stockbrokers of Wall Street had discovered the possibilities of securitization of financial products (ibid). They produced an avalanche of different new financial products that where increasingly complex (idem: 11). Securitization was not a new tool; it was first seen in the late 1970s, when there were transactions between securitized assets pools assembled from mortgages (Kettering 2007: 1557). The increase in securitization during the early 2000s, however, played a large role in the development towards the financial crisis in 2008. First, it is important to establish what a securitized financial product is. Securitization is a process that uses cash flows promised from one set of financial instruments, such as a mortgage, to provide the financial resources to back a completely new set of financial instruments (Kolb 2011: 2). This means that a financial actor can repackage their owed debts and sell them to another actor. For example, B lends 100 dollars from A. A decides to sell the debt of B, B’s obligation, to a third actor C. C is now entitled to the debt of A. This might seem as a straightforward transaction, actor A sells the debt she is entitled to from actor B to actor C. These transactions become increasingly complex, however, as actor A also adds her other owed debts to the product sold to C. She adds the debts of D, E, F and G to the product. The product is now a securitized bond backed by several different financial actors. These products are often referred
10 to as collateral debt obligation (CDOs). A CDO is a mutual fund for bonds and loans (Zandi 2009: 117). These securitizations are backed by the collateral, such as mortgage loans (ibid).
2.3 Mortgages as the Cornerstone
The next step is to see how this exactly works with mortgages. A mortgage is based on a fairly basic principle. Most of the time, it is concluded by an individual borrower and a single lender (Zandi 2009: 11). The single lender is a bank. An individual borrower can apply for a loan for a house, a car or another high expenditure. Mostly mortgages are given out for the purchase of housing. The individual borrower would pay their debt back over time including interest. In this sense, a mortgage acts as a single debt agreement between two parties (ibid). The bankers of Wall Street found that securitizing the mortgages to make them tradeable worldwide was a profitable business. The relation between the borrower and the lender now diminished. With hundreds of mortgages pooled in the same securitizations, there was no longer a simple single debt agreement. The original bank would still handle collecting the money and resolving the paperwork, but the cash flowed towards the international investors of the securitization (ibid). This made the financial products that were traded more and more complex. To increase complexity further, bankers found that these securitizations could be offered in tranches (ibid). Tranching securities means dividing the risks inside the financial product. The word tranche is French for slice or portion. Tranching is a complex tool of making slices of financial products in a structured way (Coval et al. 2009: 630). This structuring has two steps to it (ibid). The first step is to pool different securities in a financial vehicle. These securities vary from bonds to loans, credit default swaps and other financial products. The several securities are now collateralized in a security derivative. These Special Purpose Vehicles (SPVs) therefore consist of multiple types of securities, all with different liabilities and risks attached (Brennan et al. 2009: 895). The idea behind tranching is to divide these liabilities into different seniorities, ranging from senior tranches to mezzanine tranches to junior tranches (ibid). The importance of these tranches comes from the prioritization of payment. The payments towards the tranched product first go to the senior tranches and will be transferred to the junior tranches last (ibid).
Investors are now capable of sizing up the risk they are willing to take with the product. Tranches offer the opportunity to generate different levels of risk on a bundle of financial products (Acharya & Richardson 2009: 199). The amount of risk taken with the product reflects the amount of possible return. When an investor wants to make a safe bet on a senior tranche, they would have a lower return on the profit. The way it works is that the investments in the
11 senior tranches get payed first when the cash flow dries up. The riskier investments (the mezzanine and junior tranches) carry more risk because these investments get payed later in the cycle. If the cash flow dries up, there is a chance the money is already transferred to the safer investments. However, the riskier tranches of the products offered a much higher return on the investment. These risks are indexed and rated by Credit Rating Agencies (White 2010: 213). Issued financial products would obtain a rating ranging from AAA (the famous triple A rated bonds) to BBB (ibid). These ratings are necessary for the market in order to solve problems surrounding information asymmetry (Brennan et al. 2009: 896).
These ratings help improve the understanding of the risk of these financial products, which helps increase the liquidity of the market in good financial times (Holmstrom 2015: 15). However, everything that adds liquidity to the money markets in good times, can risky when a crisis emerges. The system relied on trust in the rating agencies and underlying collateral of the obligation, in this case mainly mortgages (ibid). Due to the complex nature of the tranched securitized derivatives, it became more and more opaque for investors to establish how high the risks of these vehicles were. With hundreds of mortgages bundled it becomes increasingly complex to pinpoint every situation of every individual (Lowenstein 2008). However, they did not have to find out for themselves, as the vehicles were rated by the Credit Rating Agencies (White 2010: 213). This is important for the development of subprime mortgages, as the housing market was deemed historically solid by the financial world. The trust in the housing market extended towards the credit rating agencies (Brennan et al. 2009: 896). This ensured that credit markets rated the mortgage backed financial products as safe. With the financial products receiving a high rating due to them being backed by the housing market it becomes evident that these apparent benefits of securitization were huge for the financial market. Historically, mortgage markets offered local opportunities by being single debt agreements between the borrower and the lender. With the new system, it became possible to make even more money on mortgages by selling them to international investors. The scale of involvement of different parties in the national mortgage market of the United States became global. The other benefit for banks was that they gained a lot more liquidity (Zandi 2009: 12). A bank needs liquidity in order to give out loans to borrowers. With this development, banks could securitize and sell their owed debts. This opened up the opportunity for banks to generate a loop of creating loans. With the money acquired through selling the mortgage-backed securities, they were able to hand out new loans. These news loans could be securitized and sold again on the international market. At the time, this seemed as a loop that would keep increasing their profits. In theory, as long as there are investors willing to invest in the securitized products, there would be money to lend to individuals. Banks seemed to believe that they could not run out of credit using this method (ibid). This development is important in
12 understanding the unbridled growth of the financial sector leading up to the financial crisis. The notion of risk was slowly diminished by these bankers, as for them it seemed that this would work indefinitely. This was especially true for American bankers, as they lend their money to borrowers who found themselves in the safest, most stable economy of the world (Zandi 2009: 9).
The housing market, and therefore the mortgages that accommodate the housing market, in the US was very appealing for foreign investors (idem: 13). Historically, Americans had been very reliable when it comes to making rent payments on their mortgages (ibid). Next to the reliability of the down payments of the Americans, the housing market itself was perceived as one of the most stable (ibid). Houses were seen as one of the safest investments for individuals. The price of houses hadn’t declined a single year since World War II (ibid). There was a notion among the citizens of the US that there was little to no risk in investing in a house. Another facet of the surge towards owning homes is a cultural one in the United States. Central to the classical American dream, owning a home is seen as a sign of economic well-being (idem: 47). Next to employment, owning a house is a big part of the American dream (ibid). With the rise of cheap credit, many people took the chance to buy a house using a mortgage. Afterall, buying a house was the safest investment. In a timespan of ten years, from 1995 until 2005, home ownership rose by 5% (idem: 48; BOC 2019). In 2005 69% of the households in the US owned a house (BOC 2019). This number was unprecedented in the history of the United States. This shows the increase in the possibility for first-timers to buy a house. It needs to be clarified that this part of society is not the only part that profited from the higher availability of credit. Next to these first-timers, current house owners would seek to trade-up on their house or invest in their current house. The same argument applies here, with credit and houses seemingly being an investment with less to no risk, it would be unwise to not invest in your own house or to look for a bigger, better place to live (idem: 56-67). This drove up the demand for credit.
The combination of the high demand for credit and the seemingly unlimited supply for bankers generated a spiral that kept intensifying. The banks needed more people to lend out mortgages, as they could sell these mortgages as collateral debt obligations to make more money. This resulted in the lowering of the requirements for people to qualify for a mortgage (idem: 32). The lesser qualifications introduced the world to a now well-known concept when analysing the financial crisis: the subprime mortgage.
With the incentive for banks to keep handing out loans, the bar for applying for a loan diminished. Due to the tranches in the securitization, it was not a particular problem if one of the borrowers from the security defaulted on their payment. Due to the structure of the
13 securitizations the riskier mortgages were simply tranched in a lower tier of the product. As mentioned before, international investors still wanted to invest in the riskier tranches. The risks seemed negligible as the housing prices were ever rising (idem: 91-92). To facilitate the international demand for investment vehicles the bankers tried to further lower the standards for obtaining a mortgage. For example, borrowers were no longer required to obtain insurance on their mortgages (idem: 29). This took out the need for down payments in advance of receiving a mortgage. This opened up possibilities for several different financial constructions to borrow as much money as possible.
Borrowers can be defined in three different categories. There are prime borrowers, alternative-A borrowers and the subprime borrowers (idem: 32; Kolb 2011: 25). Prime borrowers may have missed one or two payments on previous loans, but not more than that. They are proven to be credible and to have the resources to be able to pay their loans (be it a job or enough capital). The next classification was the alternative-A borrower. These were borrowers that were deemed credible, but had done something wrong in the past. For example, missed a couple of payments on previous loans. The third category is the subprime category. These people had been faulty with previous loans or did not have any credit history at all (ibid). These categories were based on a FICO score, and interest was adjusted to these ratings. Increased interest ratings for riskier borrowers is logical, more risk requires more reward. The solution to circumvent the problem of people not taking mortgages due to high interest ratings was to introduce the Adjustable-Rate Mortgage (ARM) (Kolb 2011: 50-51).
An ARM uses an adjustable interest rate. The rate can fluctuate up or down, and can be indexed to certain benchmarks (idem: 289). ARMs were not completely new in this period. In the last quarter of the century ARMs were offered to borrowers who were perceived as prime borrowers (Zandi 2009: 35). During the housing boom this changed drastically. Due to the nature of ARMs they could be offered with a low starting interest rate. This lured subprime borrowers to these ARMs, as the starting interest rate were low, and the increase of the rate seemed far away. Again, it is important to underline the notion that it was perceived that houses only went up in price. Why would someone mind paying more interest in the future for an asset that would keep increasing in value? These incentives for lending showed, as 90% of the subprime loans in 2006 were ARMs (ibid).
An important point in this development is that with this increasing complexity it became increasingly difficult for ‘the average Joe’ to evaluate the consequences of accepting the terms of a mortgage. Many saw the huge supply of credit as a once in a lifetime chance to finally live up to the American dream of owning a house. Lured in by the teaser-rates many people signed up for an ARM without even understanding that their interest rate would go up over time (idem:
14 54). Of all ARM borrowers, 41% did not understand various features of their ARM loans (ibid). This number is even more astonishing when it is considered that 90% of the subprime loans were ARMs in 2006. Individuals would need extensive financial knowledge to be fully aware of the long term consequences of accepting these terms for their mortgages. This is an obvious foundation for a financial crisis. All it took was the bursting of the inflating housing bubble.
2.4 From Boom to Bubble, from Bubble to Bust
A financial bubble can be described as trade in large volumes at prices that are higher than their intrinsic value (Girdzijauskas et al. 2009: 269). This comes down to the price of an asset being disconnected from its fundamental value (Zandi 2009: 162). These bubbles can develop around all kinds of (financial) products. Real estate bubbles can develop when housing prices increase rapidly. Normally house prices grow similar to the levels of domestic inflation or an overall increase in income (Girdzijauskas et al. 2009: 269). However, the expanse of the price can grow in larger proportions. This can be due to speculation on the housing market, or if the trust in the housing market is overoptimistic (ibid). Due to the wide availability of credit in the US the prices of houses went up in rapid succession. This was not seen as a warning, as the price had historically been increasing (Zandi 2009: 161). When prices get too high, the bubble bursts and prices plummet (Girdzijauskas et al. 2009: 269). With real-estate this is rather troublesome, as a house is the largest and most important asset for many individuals. In the beginning of 2007 the housing prices reached an all-time high in the US (Kolb 2011: 57). The previous years had built up to a point of immense speculation on the housing market. During the housing boom the increase in prices was based on the fundamental principle of supply and demand (Zandi 2009: 161). When the real estate market fell to speculation, this can be seen as a shift towards a bubble. It is important to understand that speculation not only refers to men in pin-striped suits who are looking for a sound investment. As mentioned before, almost everyone in the US assumed that prices would keep on rising and made investments on that particular assumption. Every first-timer using the opportunity to hop on the bandwagon of this unbridled availability of credit was speculating at this moment (idem: 162).
At the end of 2006 the real estate bubble started to rupture. Mortgage loans started to show signs of defaults (ibid). It did not take a long time for those defaults on mortgage payments to turn into foreclosures on the houses. This was partly due to people who bought and sold houses in short succession in order to ‘flip them for a profit’ (ibid). The houses would not sell for the demanded high price, which in turn meant that the loans they took for the purchase of the house could not be paid off. This was the first wave of defaults that would cause the financial crisis of 2008. The second wave came later in 2007. The defaults in the second wave were mostly subprime borrowers who had ARMs. Most of the ARMs were 2/28 loans (idem:
15 166). This meant that these borrowers enjoyed a rather low interest rate but after two years the rates would be reset. On average, this meant an increase of 350$ on monthly payments (idem: 166-167). For most of these subprime lenders this was simply too high of an amount to cope with. This development caused more than 1.5 million defaults on mortgages (ibid). And most of those mortgages were securitized and sold internationally. The trust in the American economy was gone, the housing market plunged into a free fall, and no one knew what their financial packages were worth, as the increasingly complexity of the products made them intangible. The rest of the financial crisis is history.
2.5 The role of Private Credit
Looking back on these events leading up to the crisis is important to understand what can go wrong with private credit and the role of banks in this process. This chapters shows how uninformed decisions by borrowers can lead to huge problems in the long term if they do not understand the terms of their loans. On the other hand, it shows that having a banking system that is built on profit can cause bankers to overlook serious risks. This reliance on debt in order to provide with more profit caused the financial system to become more and more fragile. In hindsight, the 00’s can be described as a period in the United States where positivity turned into collective greed and financial irrationality. It is the aim of this thesis to look into the possibilities that would help prevent credit markets from having such a devastating effect on the global economy. Due to the highly increased opaqueness of these financial vehicles it became more and more difficult to accurately predict the overall risk of one product. Exactly pinpointing the likeliness of default on one mortgage can be a difficult task, let alone analysing the risk on a financial product bundling hundreds of them. With the credit rating agencies deeming these products as a safe investment, the floodgates opened for international investors. This increase in liquidity for banks generated an incentive to hand out more and more (subprime) loans in order to keep the cycle going. This chapter showed how the financial system developed a dependence on the payments of mortgages. The embeddedness of private credit was a large factor in the development of the financial crisis. It is important that the private credit platform diminishes this risk. The next step is to look into the normative spectrum of credit, as it not only focuses on the probability of crisis. It is important to understand why credit is important for society to function, aside from the implications it can have for the global financial system.
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Chapter III: The implications of Credit for Society
3.1 Credit as a Mechanism for Injustice
This chapter will focus on the second argument for why private credit markets need to be improved. The first chapter focused on the possible practical implications of private credit markets. It was needed in order to justify why the credit market is in need of improvements. As the financial crisis of 2008 unfolded, it became clear exactly how big of a role mortgages (and therefore private credit) played in the financial system.1 These practical problems show why there is a need to make changes. Following the practical argument for this thesis, there is also a normative claim to be made about private credit markets. As shown in the previous chapter, knowledge of one’s mortgage terms is crucial in preventing defaults on the payments of the loans (Zandi 2009: 54). In 2006 41% of the subprime borrowers with an ARM loan in the US did not understand the lifetime cap of their mortgage (idem: 55). With this misunderstanding of their loans, the required payments for the mortgages became simply too high for the subprime rated borrowers to pay (ibid). I have shown that these defaults on the mortgages have had quite an impact on the financial system. Now it is true that this is due to the increasingly international nature of the securitized products. The vagueness of the securitized products ensured that the crisis took a heavy toll on the global financial system. However, this is just one part of the argument for why individuals should be well informed on their private credit loans.
Private credit loans can be perceived as a mechanism for structural injustice in society (Herzog 2016: 412). If we perceive these private credit loans as such, it becomes possible to develop another argument for changing the private credit market system for the better. First, this chapter provides insight on why credit is perceived as necessary for the correct functioning of modern society and how credit can provide individuals with more ‘freedom’ (Graeber 2014: 380; Herzog 2016: 412). With a focus on the implications of credit on structural injustice it becomes evident that credit plays an important role in society, but that the institution of credit
1 Private debt can come in various different forms, ranging from mortgages to student loans to credit card
debts. The first chapter focused mainly on mortgages, as mortgage make up for the most debt for individuals on average, at least in the United States (Herzog 2016: 411). To explain the practical implications of private credit, my overview of the build-up towards the financial crisis focuses mostly on mortgages. Referring to mortgages, and therefore to private credit, is done in this way because the focus lies on the similarities
between the different types of private credit (idem: 412). The difference between a student loan or a mortgage loan is evident, but it does not affect the argument of this thesis.
17 can also cause impediments for the freedom of individuals. I will explain that credit can only be seen as liberating when meeting certain criteria (Herzog 2016: 412).
First I will explain how the concepts of freedom and structural injustice are defined. This is needed in order to establish an understanding of how they can be impacted by private credit. The next step is to identify how credit became a necessity in society. Following the explanation of how credit became crucial in society, it is important to determine which facets of the private credit market might undermine the liberating potential of credit. This is important as these facets contribute towards structural injustice. This chapter will focus on three facets of the private credit market that are deemed to increase social injustice by Herzog (2016). These facets are a lack of fully informed rational consent, the lack of access to credit, and overly expensive credit (idem: 415-416). The last step is to identify the problem of predatory lending, whereby lenders can actively make use of these societal flaws in order to generate more profit for themselves. This chapter concludes by summarizing the normative claim of private credit markets being a mechanism for structural injustice. The conclusion also reminds us that credit has a liberating function in society. This liberating function is crucial for understanding what mechanisms of the private credit markets need to be improved.
3.2 On Freedom and Injustice
3.2.1 Freedom
It can be argued that processes of economic, political and social development are basically used for increasing the freedom of individuals (Roodman 2012: 11). This notion comes from Sen, who argues that this is not only about having a libertarian freedom from interference, but also refers to greater agency for individuals (ibid). The notion that economic development is essential for increasing freedom is important for determining the role of credit when it comes to freedom. It is logical that having a high income increases the amount of freedom an individual has, but how does this relate to credit? Credit can enhance financial freedom, as it increases other freedom-enabling factors in the long run, such as education and income (ibid). This will be addressed later in the chapter. First it is important to define the concept of freedom before looking at the implications of credit on freedom.
Freedom (or liberty) can be defined as four different types. It is important to note that these types do not necessarily contradict each other, but mostly function as overlapping archetypes of what freedom can entail. The first important distinction to make when discussing freedom is the difference between positive and negative freedom introduced by Isaiah Berlin in 1958 (Flickschuh 2007: 12-13). The type of negative freedom can be understood as the absence of obstacles (ibid). These obstacles can be physical barriers, constraints or interference from
18 other actors (Carter 2018). For example, an actor wants to do their groceries at night. The actor has the freedom to go the supermarket, but once arrived she finds that the supermarket is closed. This restricts her negative freedom. Negative freedom focuses on externalities which lie outside of the control of the actor (ibid). This brings us to positive freedom. Positive freedom refers to freedom that is provided by the presence of certain things (ibid). This can refer to control, abilities, self-determination, etc. (ibid). The difference lies in the question asked about the freedom. Positive freedom answers the question what or who the source of control is of an actor making a choice (ibid). Negative freedom answers the question what the individual is capable of doing without interference of other actors (ibid). This distinction is important in understanding if a person is in control of their freedom, or if there are other actors impeding the possible freedom that could otherwise be achieved. To elaborate on how these types of freedom differ it, the example of applying for a mortgage can be used.
When an individual who wants to buy a house applies for a mortgage at a bank it is possible that her application is declined. The bank can decide to grant the loan or not, based on her credit history, her current income or which house she intends to buy with the money. In this scenario the bank would impede the negative freedom of the individual, as the bank now asserts control over her ability to access the funds to buy a house. The type of positive freedom refers to the capabilities of the individual herself. For example, this can be the extent to which the individual understands her own preferences; does she really need to buy a house? She can be under the assumption that it is necessary to own a home in order to comply with the norms of society. These factors influence her positive freedom, as they are not external to the actor. Another example is that maybe she does not quite understand the terms of the adjustable-rate mortgage. In her mind, the offer of the mortgage is beneficial to her in the short term, but she does not understand that her interest rate rises after two years. This lack of knowledge can be seen as a limit to her positive freedom, as she would be more free to make the ‘correct’ decision had she understood the long-term consequences of the loan. Positive freedom can be understood as the lack of self-imposed constraint (Flickschuh 2008: 23). One can understand that the difference between the types of freedom is not as easily pointed out in the ‘real world’. The employee of the bank who handled the mortgage application might have left out certain information on the indexing of the mortgage. In this sense there is a barrier for the consumer. It is important to keep in mind that these distinctions are theoretical.
It can be understood that politics revolve around the concept of freedom, as the state determines the laws that can be seen as limitations to freedom (idem: 16). The discussion on how much liberty the state should provide is a staple debate in political science. This counts for both the reduction of obstacles for individuals to utilize their freedom as well as for what determines and changes the desires and interests of individuals in society (Carter 2018). The
19 prime example here is democracy. Democracy is often assumed to be the political structure that provides the most freedom for its inhabitants (ibid). However, democracy has freedom-impeding aspects. Imagine a minority group inside a democracy. They have the rights to vote and participate in the democratic system. Since they are part of the democratic system they are deemed free, but they are still oppressed in some ways in the same democratic system (Carter 2018). This is not only an issue for minority groups; it is also possible that a democratic system chooses to instate a new authoritarian ruler (ibid). This shows that freedom can have paradoxical effects.
The two types of freedom can also have paradoxical interpretations (ibid). Scholar that argue for the negative type of freedom can deny that there is a necessary relation between freedom and desire (ibid). This problem with this statement is that everything can be considered free simply by complying with the given situation. Negative freedom can also be seen to refer to the freedom needed to chase one’s desires. In this sense, the desires and interests of the individual can be viewed as their positive freedom. The following two types of freedom add steps to the positive and negative type of freedom.
The third type of freedom is the republican liberty. This type of freedom states that freedom is more than just the enjoyment of un interference. The republican liberty states that there is a need for certain conditions that provide the guarantee that there is non-interference (ibid). These conditions are the democratic functioning of the state, ensuring that the government cannot use force arbitrarily, obtain rights as a citizen etcetera. This distinction is important, as this nuances the idea of negative freedom. A helpful example here is when someone in an authoritarian state lives a relatively free life. As the state does not interfere with the person, she can be deemed as free. For the negative type of freedom, there is no connection to the way the state is structured and the level of freedom. The republican type of freedom insists that political institutions are crucial to guarantee that citizens are independent from interference of the government. This can be understood as categorizing the possibility that freedom is impeded. In an authoritarian state it is possible that the government does not interfere with specific individuals. The negative type of freedom would state that these individuals are free, as there are no parties functioning as an obstacle. The republican type of freedom adds that one is not free if there is the possibility for the government to interfere.
The fourth type of freedom can be classified as the positive liberty which is content-neutral (ibid). Its proponents point out that positive freedom is too much concerned with how people construct their desires and interests. Positive freedom lacks understanding of the contents of the desires and interests of people. Making a rational choice does not have to be the best possible choice. Is a person unfree if their preferences are structured by an oppressing
20 society? As an example, one can look at the widely shared desire of owning a home in the United States. As mentioned before, there was a cultural factor leading up to the financial crisis, as people perceived that they should own a home in order to live up to the American Dream (Zandi 2009: 50-55). Does this mean that these people were unfree when they made the choice of buying a house? These people can be deemed positively free, as they desired something and opted to make choices that tried to fulfil their desires. The positive freedom type II thinker would argue that these perceived interests were constructed by society, and therefore would deem that these individuals were partially unfree in their decisions of acquiring a home.
3.2.2 Structural Injustice
Injustice can be seen as a lack of fairness (Sen 2010: 53-54). Justice can be perceived as fairness and therefore injustice would refer to a lack of fairness. First, it is important to distinguish what fairness means in this context. Justice as fairness stems from the ideas of John Rawls (ibid). This notion of justice is constructed through what Rawls calls the ‘veil of ignorance’. This veil of ignorance is needed to prevent bias when determining what is unjust. This is important, as it diminishes the effect of prejudice, predetermined interests or personal priorities (ibid). This is needed to provide us with a basic understanding how justice has to interpreted. The veil of ignorance is a thought experiment that places people in an ‘original position’. This original position is an imagined position in which there is a primordial equality (ibid). This means that the individuals are unaware of their own position, interests and desires in society. They are also unaware of the positions of the other individuals. The idea here is that, under these circumstances, the group decides on what the principles of justice are unanimously. It is important to note here that there are also no perceptions of what a ‘good life’ is (ibid). This would create the right conditions for the group to properly determine what is just and what is not. The veil is important, as it assures that nobody would act purely out of own interest, as they are not sure what those entail. In this sense, justice is established anonymously based on an impartially determined fairness (ibid). This can be understood as a conceptualization of fairness which would provide equal terms of justice for all participants in society.
The notion of injustice focuses on the context and background of unjust principles in modern society (Herzog 2018: 414-416). This idea of structural injustice is argued by Young (ibid). In many economic models, injustice is defined as an outcome of individuals’ rational choices (ibid). It is important to note that social positions in society can also be crucial in developing unjust situations. Young argues that injustices can be created by a collection of factors that are large in scale, multiple in numbers and mostly long-term (ibid). These factors can be difficult to narrow down, as this theory does not focus on actions, but on the positions that actors hold
21 in society. Structural injustice can exist when certain groups of people are under a systematic threat of domination or deprivation affecting their ability to widen their capacities. It is important to note that this notion of structural justice relies on the generation of principles of fairness under the veil of ignorance. This means that people with different beliefs of what the ‘good life’ is will come to terms with conditions that are fair for all (Sen 2010: 55).
Structural injustice grants some actors the ability to dominate the development of capabilities of other actors (Young 2011: 52). This means that there are groups in society that are privileged, and that there are groups in society that are hindered in developing their capacities due to their structural social position (Herzog 2016: 415). For example, there is a distinction between more highly educated individuals and people who did not enjoy an education, as regards their understanding of how their mortgage functions. 14 % of the people who enjoyed a college education did not understand how part of the indexing worked on their ARM in the United States (Zandi 2009: 54). 43% of the people who enjoyed an education lower than college did not understand parts of the indexing of their ARM loan (ibid). This indicates that more highly educated people understand the conditions of their mortgages better, receive better information on how their mortgages function or are more inclined to read the small print of the mortgage contracts. In any case, this difference in simply understanding how their own mortgages function is significant between two groups in society. It would be too simplistic to assume that the difference between the groups is due to individual choices in both groups. But why is it important to understand the differences for analysing injustice? Credit can be seen as necessary for functioning in society, as it can have a liberating function.
3.3 The Necessity of Credit
First, it is important to analyse what credit is, and in order to understand how credit can be necessary to function in society it is important to determine what debt exactly is. Debt requires a certain relationship between two actors that are equal in principle, but find themselves in a moment of inequality (Graeber 2011: 120). This can be envisioned as one actor (A) owing something to the other actor (B). Actor A is indebted to the other actor. The relationship is considered unequal as one owes something to the other. Another factor of debt is the assumption that is in going to be repaid (idem: 121). While the debt is not repaid, the situation of inequality remains (ibid). This makes debt inherently based on reciprocity. This is crucial in understanding how private credit functions, as it is expected that the debt is always paid off. Someone can take on a debt, but this always creates a hierarchy where one party is unequal to the other. This raises the question why individuals would want to position themselves in an unequal situation where they are indebted to another actor. This would limit their negative
22 freedom as they would now have an obstacle in life by having to repay the debt. The reason is that taking on a debt can also be liberating for individuals instead of impeding their freedom. To understand why credit can be liberating for individuals, it is beneficial to again turn to mortgages in order to have an example for why this is the case. Mortgages provide the possibility for individuals to purchase a house. This is obvious, but it is useful to strip this process down to the very basics. Buying a house is an especially expensive endeavour. Most people do not have the resources to buy a house from their own pocket. In search of the liquidity to pay for the house the individual goes to a bank in order to borrow the resources for an otherwise ‘too expensive’ purchase. This can be seen as a liquidity constraint (Meyer 2018: 309). The individual might have a steady income from a job, of which she would be willing to pay a part every month in order to afford the house. As described in chapter 1, the bank is also interested in handing out this loan. In this sense, both parties have “gains from trade” (Heath 2006: 320-321). The banks have a productional interest in the mortgage, and the individual now has the ability of consumption of the product of her own choice. She is now able to purchase the house she wanted. This consumption side of credit improves multiple types of freedom of the individual (Herzog 2016: 412). It improves the negative type of freedom, the positive freedom type I and republican freedom. It enhances the negative freedom as it removes the physical barrier to having a solution to a liquidity constraint. It enhances positive freedom type I, as it is now possible for individuals to acquire a home. The question is not how the desire to own a home is generated, but if owning a home is what the individual wants; it now becomes possible through credit to pursue this desire. The republican type of freedom is improved, as the institutions of private credit provide society with the opportunity to make use of this dynamic.
One could, however, make the argument that the monthly payments on her mortgage impede her future financial freedom (ibid). She has to make a payment every month, reducing the amount of resources she has and freedom she has. The mandatory repayments generate new limitations to her negative freedom (idem: 413). However, the increase of freedom by removing the liquidity constraint on buying the house might increase her freedom overall (ibid). Next to the liquidity constraint, one can argue that the individual now has the freedom to determine how she wants to acquire the necessary resources in order to pay back her loans (ibid). The
liquidity constraint can be explained as the lack of liquidity of the individual, not a lack of
solvency (Meyer 2018: 309-310). As shown before, the individual still has to earn enough money in the future in order to pay back the borrowed money.
The attentive reader might have immediately thought of the subprime borrowers of chapter I. This shows that certain requirements have to be met in order to be able to receive a loan. The
23 necessity of credit does not automatically mean that everybody is simply entitled to an infinite
amount of resources through loans (idem: 305-306). This chapter does not try to argue that
everyone should be entitled to credit, but tries to show the liberating features of credit. With credit increasing the freedom of consumption of individuals, it becomes evident that credit is necessary for individuals in contemporary society. However, as shown in chapter I, the solution is not to just lend money to anyone willing to take up a loan. This is one of the problems the model presented in chapter 4 will try to solve.
When someone is indeed sufficiently solvent to apply for a loan, it becomes evident why credit generates the possibility for them to live their lives as they see fit (Herzog 2016: 412). A lack of access to credit can shut down the possibilities for individuals to start businesses, own a house or to enjoy an education (Meyer 2018: 306). This is why credit plays a crucial role in contemporary capitalist societies (ibid). The reason this is especially important for capitalist societies is the defining feature of private property (idem: 307). In a society where ownership is not established or protected by law, it would not improve one’s freedom to buy a house. The central role of private ownership increases the importance of having access to credit. This shows why the accessibility of credit can be seen as an improvement of the three types of freedom mentioned before.
The types of freedom which benefit the most from credit are the content neutral positive freedom (type I) and the negative. As shown in chapter 2, owning a house was a large part of the American Dream (Zandi 2009: 47). This is reflected in how the average debt is distributed among US-Americans. On average, US-Americans have $15,000 credit card debt, $33,000 student loan debts and $156,000 mortgage loan debts as of 2015 (Baradan 2015: 110). These figures show the importance of credit in contemporary society. The access to credit can help overcome the problem of lack of resources. Without credit, it would be financially impossible for many people to enjoy an education or to own a home. This shows that credit is a necessity. It is important to repeat that this thesis does not argue that therefore credit should be available for every individual for anything, but that it is a cornerstone of modern society. This implies that a well-functioning private credit market is needed in order to provide a structurally just society. However, it is important to understand how credit acquired such a pivotal role in society. Indebtedness is a highly debated topic since the financial crisis in national as well as international politics (Graeber 2011: 5). Discussion focuses on public debt as well as private (consumer) debt. An example is the major increase in debt overall. The Federal Debt of the United States alone increased from 253,400 million dollars in 1951 to a staggering amount of well over 12,000 trillion dollars in 2018 (Graeber 2011: 266). It can be understood that this
24 increase in indebtedness is heavily debated and criticized. How did the world end up being so heavily indebted?
One way of looking at it is to take into account how debt is created. A small-scale example can provide understanding of why this immense increase in indebtedness is not necessarily a problem. There are three actors in this example. Actor A has one dollar and lends it to actor B. Actor B is now 1 dollar in debt. B lends her dollar to actor C. C is now in debt with B, who is in debt with A. Actor C lends the dollar to actor A. In this small example, there is now three dollars of debt, while there is only one dollar in circulation. This shows how debt can accumulate so rapidly. It is important to note that this is not necessarily problematic, but that it does provide a recipe for possible financial disaster. This can also be seen in the example with the three actors. If actor B demands that the credit she provided for actor C is paid, actor C needs to get his money back from actor A. This can be done in this example, but when the amount of actors grows exponentially one can understand that repaying all debt in the world becomes an impossibly complex task. But why did the world let it come this far?
One could make the argument that this comes down to how capitalism functions. The development of the neoliberal point of view in the political economy ushered in a new phase of capitalism: privatized Keynesianism (Streeck 2014: 38). With the demise of the Bretton Woods system, the global economy saw an increase in financialization (Wiedenbrüg 2018: 368). This increase resulted in easier access to credit, which provided for more financial instability (ibid). In this adaptation of capitalism, the state replaces public debt with private debt, in order to expand the resources available to promote economic growth (Streeck 2014: 38-39). The idea here is that the state decreases their regulatory policies. As shown with the increase of the federal debt of the United States, this does not mean that the debts of the government decreased. The use of public debt was diverted away from welfare regulatory policies. With the decrease of regulatory policies, it became necessary for households to supplement their income and welfare with private debt (idem: 39). Households were now expected to take on these loans at their own risk. This change is due to capitalism being dependent on growth. In order for the economy to grow, it became necessary that consumers had more money to spend in order to consume more.
The shift from public debt to private debt lifted the weight of the post-war responsibility of the state for growth and social security (ibid). This shift was due to the belief that capital markets could regulate themselves and were not in need of government regulation (ibid). This belief is based on the idea that the participants of the capital markets would dispose of all the necessary information in order to prevent systematic imbalances (ibid). The ongoing deregulation and privatization of the capital markets culminated in the financial crisis of 2008 (ibid). The process
25 of the increase of privatization and deregulation of capital markets can be seen as undemocratic. Democracy and the neoliberal capitalist system can be perceived as partially incompatible, as the representative public authority is tasked with ensuring that economic goods are somewhat fairly distributed in society (idem: 57). Under the assumption of assured prosperity, growth ensured that the capital markets would be more and more privatized, leaving less and less room for representative bodies in the financial markets (idem: 15).
The reason this can be perceived as a critique on the increase of the role of private credit in society is that states turned away from their role as a welfare state. The welfare state diminished as increasing parts of society were commodified (idem: 28). This implies that society now has to attain the same level of welfare at individuals’ own risk instead of on the collective risk. The difference is evident. The welfare state regulates certain facets considering social and economic issues for society. When the welfare state diminishes, people are dependent on their own capabilities of ensuring their income and supplementing this income through private credit. This change towards the more individualist approach increased the vulnerability of some groups in society, as they were now reliant on the capital market instead of their government.
It is important to note that all countries handled this transition differently, and all states are not completely similar. However, the decay of the welfare state towards a more market-oriented society, towards privatized Keynesianism, was a trend in the western world starting in the 1970s (idem: 31). The issue is that the governments steered their citizens towards private credit instead of making growth available through the functioning of the welfare state. Growth is crucial for capitalism. This generated a need for private credit, as the system relied on growth. With the welfare state diminished, private credit became a necessity for society to function in the capitalist system. The development of consumer credit became a large part of the economy. The easy access to credit was to supplement social services. This shows how society become more and more debt reliant. When the economy became fuelled with consumer credit, this maximised the possibility of a financial crisis. This is due to dependency on credit for the system to function as a whole. When a financial shock occurred, many failed to make their payments on their loans, causing the system to collapse.
3.4 The Implications of Private Credit for Structural
Injustice
It is important to focus on the implications of private credit for structural injustice. Private credit markets have an influence on structural injustice. This is due to three factors, which revolve around the structural injustices caused by the current system of private debt markets (Herzog
26 2017: 411-412). These structural injustices include a lack of fully informed rational consent, lack of access to credit and overly expensive credit (idem: 415-416). These factors render private credit markets on their own ‘unjust’, even as they function as a mechanism to improve unfairness in society. With some groups within society struggling to gain access to credit or to systematically pay more for credit, it becomes evident that this provides unfair benefits for the groups that do not systematically have these issues. A lack of fully informed rational consent further increases these gaps in society. As mentioned before in this chapter, credit became a necessity for households due to the changes made to the welfare state. Therefore, it is seen as an injustice if there is a difference in understanding, accessibility and price for different groups within society. This is based on the fairness principle of justice, as under the veil of ignorance, one can assume that the group would decide that it is only fair if everyone had to live by the same rules. In this sense, in the ideal situation, there should be no overpriced credit for certain groups in society, there should be no difference in the ability to access credit and everyone should have the same amount of information available to them in order to make an informed decision.
It has to be noted that the way in which credit became a necessity, through the diminishing of the welfare state, could also be perceived as a structural injustice. This creates a debate on the role of the state in supplying social and economic regulations. This normative debate is central to politics. However, while this debate continues it is possible to distinguish certain criteria for credit to function. For example, it is logical that someone without income cannot have a large loan granted to them, as there is no benefit for the creditor. The creditor cannot rely on the debt being repaid. One can argue that, in an ideal world, the idea of credit is not even present then. However, this is not how the world functions. This thesis aims to improve the current situation in private credit markets, and therefore will focus on the current structural injustices that are generated by private credit markets. It is acknowledged that the necessity of credit in itself reduces the overall freedom of society, but the central problem of credit being a necessity in our contemporary society cannot be addressed in this thesis. Therefore, this thesis will accept that credit is a necessity, although one can argue that this state of affairs in itself can be considered as unjust.
The first facet of the private credit market that needs discussing is the lack of fully informed rational consent. In order for credit to be beneficial for individuals it is important that they are aware of what their choices consist of. As mentioned before, credit can function as liberating, an individual is able to make a choice of taking on a mortgage. This can impede their future financial freedom because of the repayments on the mortgage. The key here is that they are able to make this decision based on the information provided on the exact amount they have to pay back monthly. The ARM loans are a good example of why it is important that individuals
27 with these kinds of mortgages know how their loans actually function. Individuals that did not know that in two years their monthly payments would be indexed again, did not have the possibility to make a rational choice on whether the mortgage was a beneficial choice or not. When they borrowed the money, the monthly payments were affordable, and therefore the choice to take up the mortgages seemed beneficial. It is difficult to pinpoint whether or not an individual would take on an ARM loan fully knowing that in two years the monthly payments would be too high to pay. However, it is logical to assume that with this information someone might decline to borrow the money or start to look for other alternatives. As shown before, the amount of people who understand their ARM loan terms varies depending on the level of education (Zandi 2009: 236). This could be due to a difference in financial literacy, but it could also mean that the educated group receives more information due to privilege (idem: 51-53). Lacking the possibility to make a fully informed decision based on belonging to a group in society can be categorized as a structural injustice for portions of society.
The second factor is unequal access to credit (Herzog 2016: 416). As mentioned before, this thesis does not argue that people who are not able to pay back their loans should have unlimited access to credit. However, access to credit can provide opportunities for individuals. They can consume products they would otherwise not be able to afford due to the previous mentioned liquidity problem (Meyer 2018: 309-310). Individuals could also borrow money in order to start enterprises, which would prove beneficial for the economy as a whole (ibid). Without access to credit, it becomes problematic for individuals to overcome liquidity problems. One reason why people are denied credit is the lack of having the appropriate documentation in order to be able to apply for a loan (Herzog 2016: 416). Having the proper documentation in order to be able to apply for a loan does not indicate whether an individual is solvent or not. The denial of a loan on these grounds can impede the capacities of individuals, because they do not fulfil all the set out requirements. The lack of access to credit can therefore create a structural injustice, as certain groups in society cannot meet the requirements of applying for a loan, whilst they are indeed sufficiently solvent to pay back the loan. This can be seen as impeding the freedom of the individuals. Without the ability that credit could provide, these certain groups in society are structurally hindered in maximizing their capacities.
The third factor is that credit can become overly expensive (Herzog 2016: 416). The way a credit market ought to work is that the amount of the monthly payment is tied to the risk of the loan (ibid). This is the central mechanism of the financial system: the higher the risk, the higher the pay-off has to be in order for the interaction to be beneficial to both parties (Heath 2006: 320-321). This idea of the gains of trade for both parties is central to private credit markets. However, in the actual indexing of the rates on the loans there are other factors that matter for banks. For example, different areas in the US have different rates and requirements for loans,
