The Three S's of Finance
By Arnold Kling
Think of financial intermediation as consisting of three S’s:
Spreading (that is, using diversification of risk)
Selecting (that is, choosing the right risks to take)
Signaling (that is, convincing people that the intermediary is sound)
In my favorite example of fruit trees subject to disease, spreading means investing in a portfolio of fruit trees, so that you are not dependent on one tree. Think of an index fund.
Selecting means choosing carefully the trees in which one invests. This means spending money to gather data and developing skills to process that data in a way that allows the intermediary to select the trees least likely to suffer from disease.
Signaling means doing something to convince investors that you are skilled as an intermediary. How can an investor tell the difference between an intermediary that is skilled at selection and one that is merely pretending to be skilled? There are various signaling mechanisms. Banks used to present consumers with fancy lobbies and immaculately dressed employees in order to signal soundness. Today, they put the “FDIC insured” symbol on the door to signal soundness.
Signals can lose their credibility. AAA-rated asset-backed security is no longer a trusted signal.
I think that focusing on the signaling aspect of finance is an appropriate role for Masonomics. There is a lot that one can do with this approach.