What I'll attempt to do now is to illustrate how the banking system works, how they make money and where the public comes in. This is the key to understanding how the system was abused and why all investors were hurt by what transpired. Worse, this crisis has spread to non-finance industries and has made a real impact on people and their lives.
Banks are very unique animals in the business world. Their simplest functions are to collect deposits from those who have spare cash, and make loans to those who need cash. These 2 things are their basic roles in life. Taking in deposits is pretty simple and is the side of the bank that most of us are familiar with. It simply is the bank being a place where you can deposit your money in exchange for certain things -- safety, a certain interest rate, convenience (ATMs, checkbooks, other banking services).
The key to this crisis is the other function of banks -- lending.
Lending money has risks attached to it. And banks are their to spread the risk, and minimize its impact for individuals.
Think about it this way -- Suppose someone knocks on your door and asks for a loan to start a business, say a restaurant. He shows you his business plans, his marketing strategy, his floor layouts, menus, etc... If you give him the loan, then you are taking on the risk that his business might fail and you don't get your money back. So to compensate you for that risk, he gives you an interest on your loan. The riskier a proposal is, the higher the interest you must demand. But if he does fail, you lose all your money that you loaned to him. Not good.
However, if he goes to a bank, then that risk is spread across all its depositors. No one single depositor faces the sole risk of this one business failing, therefore there is greater safety for everyone involved. Of course the banks still have to do their due diligence and assess what loan applications are worth taking on. After all, it's the depositors' money that they're lending out at the end of the day!
But banks cannot just make loans indiscriminately. They are restricted and limited in the amount of loans they can make. How much loans can banks make? It's set by the central banks as a percentage of their deposits and capital. So a small bank with let's say 10 million in deposits cannot make loans going to the billions because one single failure will completely destroy the bank. We in the finance world have many terms for this -- leveraging, gearing, borrowing. It's all the same. It means using a small capital base to make larger investments.
That's why the conventional banking industry is so heavily regulated. They are a crucial cog in our modern economy and yet they are also very fragile. That's why central banks regulate them and tell them how much loans they can give out. In return, some of the deposits are insured (PDIC in the Philippines, FDIC in the USA).
This is the way the conventional banking system is supposed to work. We depositors have a place that gives us safety and convenience for our money. And people and businesses who need credit and need a loan have a place to go to that will not put any single person at great risk.
However, fairly recently, there was the rise of the so-called shadow banking system. This is a term used by this year's Nobel-prize winner of economics, Paul Krugman. He writes excellent articles on the New York Times so read it if you have time.
Anyway, this shadow banking system arose because banks started to get greedy. They realized that there was money to be made if only central banks would not regulate them so heavily. So this gave rise to the other banking system that was not bound by regulations and restrictions the same way that regular banks are.
Regular banks and the shadow banks found a mutually beneficial arrangement that lead to everyone making more money. And it worked magnificently -- for a while. To give a complete picture, it was because there was a legitimate financial and business need for the banking system to evolve. But regulations were too slow to adapt to them so this separate shadow system arose unencumbered because they did not fit the traditional definition of what banks were.
Part three will deal with how this entire system failed, how it was abused and how it has led to where we are -- government bailouts, plunging stock markets, and a real recession where new jobs are harder to come by, loans are harder to get, and everyone's investment portfolio is bloodier than the Carrie's ending.
Thursday, October 23, 2008
Wednesday, October 22, 2008
The Financial Crisis 2008 -- Part One
We are living in a truly historic period in financial history. I have been in the industry for just a little over two years, so I don't make this judgment from my own observations. Rather, this was what I gathered from my seniors, my more experienced colleagues, my university professors and lecturers and reading up on history. People who have been in this industry for decades have all said the same thing -- they have never seen anything like this before. Not the Asian financial crisis, not the Russian default, 9/11 or the tech bubble affected the markets in the same way that this crisis has. I work in wealth management, and it gives me a great view of how events unfold everyday in this crisis.
One day, I know that I will look back at this and remark what a truly extraordinary time that we went through.
So this journal is an attempt to keep my thoughts for posterity, so I can look back at these events not with any bias or tilt, as we often do when looking back at the past. I invite you to share your thoughts with me if you read this. My objective is to provide some clarity to my thoughts and feelings as this phenomenon unfolds. And I hope that this helps anyone who reads this blog understand better the situation we're in.
Let me start with a little background of how we got here and set up the conditions that created this mess we find ourselves in. The modern world of commerce and finance run on a very important resource -- credit. Credit is an intangible, it is not a physical thing. But it has value. Credit, in its purest form, is simply the ability of someone to pay back money. Credit is the lifeblood of modern business for a variety of reasons. One is that it's an important source of capital. When one wants to set up a business, or an existing business wants to expand, they can take on credit to get necessary capital. Second is that it allows businesses to conduct their operations more freely without having to constantly worry about cash. For example, a real estate developer hires a construction company to erect buildings. But since the building won't generate cash revenues until it is finished and operational, then there's a mismatch of cash flow. How will the construction company pay for the materials? Pay its workers in the meantime? The answer is credit. For airlines, car manufacturers, telecom services, credit is what makes these big corporations function effectively. The same is true for almost all businesses. Think of any business and they all use credit in one form of another.
Private individuals also use credit. Credit cards, mortgages, car loans, student loans are all examples of this. It allows you to buy or pay for things based on your ability to pay for it in the future.
So who provides credit? Who makes the widespread and universal use of credit possible? It's the banking system. These institutions are supposed to keep the credit facilities open so that the economy and businesses can function as efficiently and effectively as possible.
For the commercial banks' part, it's fairly straightforward. They take in deposits from people and institutions that don't need the cash right away. They pool them and give out loans to other people who need them. They're like real estate agents where they try to match the needs of one side to another. They take in deposits and give depositors an interest, say 3% per annum. They lend to businesses at 6% per annum. And they make the 3% difference. They fondly called it the 3-3-3 principle. Give at 3, make 3 difference, and hit the golf courses by 3. Simple, supposedly. What interest rates do they set for deposits and loans? Well, this is where central banks come in.
The Central Banks of the world (this is the Federal Reserve in the USA, the Bangko Sentral in the Philippines and the MAS in Singapore for example) are the regulators of their country's financial systems.
The primary jobs of the central banks is to regulate money. In general, the easier it is to get a loan, the more money there is in the economy and vice versa. The central banks primarily regulate money through the use of interest rates. The lower the interest rate, the easier it is to get loans. So in effect, if the central banks want to encourage more lending and borrowing, they lower interest rates. If they want to discourage, they raise rates. What are the driving factors for their decisions? It's a two-fold job. The first is to control inflation, the second is to help the economy. If the economy needs a kick-start, the central banks tend to lower interest rates and encourage businesses and people to borrow. That way, more businesses are encouraged to start up or expand, and more consumtion from individuals is coaxed as well. This is called an easing or a loosening of monetary policy.
The reverse is true for inflation. If they need to combat inflation, they raise interest rates. It is called a tightening of monetary policies. Some of us may not realize it but inflation used to be a big bane of economies. In Germany, Argentina, and now Zimbabwe, hyperinflation killed the economy and was the source of instability for the countries. Imagine where the money you hold in your wallet and banks was decreasing in value right before your eyes! What you could buy in the morning, you could not anymore in the afternoon. Store merchants would display their price in markers because they need to keep changing the price within a day! Thankfully the fight against this kind of insidious inflation has been won (with a few exceptions like Zimbabwe today). But it is the central banks who are responsible for making sure that this kind of disaster does not occur.
So that's the background. We live in a world where banks are there to lend to businesses and people and that has generally contributed to our economic progress in modern times. Central banks set an interest rate that balances economic growth and the fight against inflation. And the commercial banks are there to make it all work based on the benchmark rate set by the central banks.
That's it for part one. Just a primer, a background into modern business and finance. Part two will be how the entire system works and how different players interact with one another. I'll try to give real world examples and anecdotes to drive home certain points.
And part three is how the system broke down, how it was abused by some players and how utterly misguided some participants were that created this whole mess. What I hope to do is at least provide some basic understanding of why this all happened and hope it helps you make better investment decisions. Because whether you like it or not, whether you understand it or not, this crisis is already affecting us all.
In the meantime, I hope things get better and I wish your finances are safe and protected.
One day, I know that I will look back at this and remark what a truly extraordinary time that we went through.
So this journal is an attempt to keep my thoughts for posterity, so I can look back at these events not with any bias or tilt, as we often do when looking back at the past. I invite you to share your thoughts with me if you read this. My objective is to provide some clarity to my thoughts and feelings as this phenomenon unfolds. And I hope that this helps anyone who reads this blog understand better the situation we're in.
Let me start with a little background of how we got here and set up the conditions that created this mess we find ourselves in. The modern world of commerce and finance run on a very important resource -- credit. Credit is an intangible, it is not a physical thing. But it has value. Credit, in its purest form, is simply the ability of someone to pay back money. Credit is the lifeblood of modern business for a variety of reasons. One is that it's an important source of capital. When one wants to set up a business, or an existing business wants to expand, they can take on credit to get necessary capital. Second is that it allows businesses to conduct their operations more freely without having to constantly worry about cash. For example, a real estate developer hires a construction company to erect buildings. But since the building won't generate cash revenues until it is finished and operational, then there's a mismatch of cash flow. How will the construction company pay for the materials? Pay its workers in the meantime? The answer is credit. For airlines, car manufacturers, telecom services, credit is what makes these big corporations function effectively. The same is true for almost all businesses. Think of any business and they all use credit in one form of another.
Private individuals also use credit. Credit cards, mortgages, car loans, student loans are all examples of this. It allows you to buy or pay for things based on your ability to pay for it in the future.
So who provides credit? Who makes the widespread and universal use of credit possible? It's the banking system. These institutions are supposed to keep the credit facilities open so that the economy and businesses can function as efficiently and effectively as possible.
For the commercial banks' part, it's fairly straightforward. They take in deposits from people and institutions that don't need the cash right away. They pool them and give out loans to other people who need them. They're like real estate agents where they try to match the needs of one side to another. They take in deposits and give depositors an interest, say 3% per annum. They lend to businesses at 6% per annum. And they make the 3% difference. They fondly called it the 3-3-3 principle. Give at 3, make 3 difference, and hit the golf courses by 3. Simple, supposedly. What interest rates do they set for deposits and loans? Well, this is where central banks come in.
The Central Banks of the world (this is the Federal Reserve in the USA, the Bangko Sentral in the Philippines and the MAS in Singapore for example) are the regulators of their country's financial systems.
The primary jobs of the central banks is to regulate money. In general, the easier it is to get a loan, the more money there is in the economy and vice versa. The central banks primarily regulate money through the use of interest rates. The lower the interest rate, the easier it is to get loans. So in effect, if the central banks want to encourage more lending and borrowing, they lower interest rates. If they want to discourage, they raise rates. What are the driving factors for their decisions? It's a two-fold job. The first is to control inflation, the second is to help the economy. If the economy needs a kick-start, the central banks tend to lower interest rates and encourage businesses and people to borrow. That way, more businesses are encouraged to start up or expand, and more consumtion from individuals is coaxed as well. This is called an easing or a loosening of monetary policy.
The reverse is true for inflation. If they need to combat inflation, they raise interest rates. It is called a tightening of monetary policies. Some of us may not realize it but inflation used to be a big bane of economies. In Germany, Argentina, and now Zimbabwe, hyperinflation killed the economy and was the source of instability for the countries. Imagine where the money you hold in your wallet and banks was decreasing in value right before your eyes! What you could buy in the morning, you could not anymore in the afternoon. Store merchants would display their price in markers because they need to keep changing the price within a day! Thankfully the fight against this kind of insidious inflation has been won (with a few exceptions like Zimbabwe today). But it is the central banks who are responsible for making sure that this kind of disaster does not occur.
So that's the background. We live in a world where banks are there to lend to businesses and people and that has generally contributed to our economic progress in modern times. Central banks set an interest rate that balances economic growth and the fight against inflation. And the commercial banks are there to make it all work based on the benchmark rate set by the central banks.
That's it for part one. Just a primer, a background into modern business and finance. Part two will be how the entire system works and how different players interact with one another. I'll try to give real world examples and anecdotes to drive home certain points.
And part three is how the system broke down, how it was abused by some players and how utterly misguided some participants were that created this whole mess. What I hope to do is at least provide some basic understanding of why this all happened and hope it helps you make better investment decisions. Because whether you like it or not, whether you understand it or not, this crisis is already affecting us all.
In the meantime, I hope things get better and I wish your finances are safe and protected.
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