Session 6 will reiterate the now familiar twin mantras: do not default, do not go bust. And we repeat a banker’s to-do list that involves gathering more information, diversifying, smart contract design, keen risk pricing together with plenty of capital and liquidity buffers.
Around a decade ago, the global financial system went into meltdown. What seemed so shocking at the time was that, despite the apparent sophistication and smartness of modern banking, the financial system proved tragically fragile and vulnerable. In 2011 a senior Chinese central banker reportedly said to Lord King (former governor of the Bank of England)
“We in China have learnt a great deal from the West about how competition and a market economy support industrialisation and create higher living standards. We want to emulate that… But I don’t think you’ve quite got the hang of money and banking yet.”
The GFC was partly bad luck but, in finance, as in many walks of life, you make your own luck. Risk is typically endogenous not exogenous.
We shall learn that the property reversal from 2005 onwards was the GFC trigger, but the problems went much deeper
You will notice that many of the GFC problems we list are common features in many past crises. The narratives vary but the underlying themes are remarkably similar. So why do we keep making the same mistakes, over and over? Human foibles – greed and fear – play their part. Certainly, the ancient Greeks warned about hubris and nemesis, and yet many centuries later, the trap is still catching the unwary.
On the theme of human irrationality, the 2017 winner of the Nobel Prize in Economics, Richard Thaler has broadened our understanding. He makes a brief appearance in the following Big Short clip, with Selena Gomez, to describe one particular GFC folly (the synthetic CDO). Enjoy – and don’t skip the awesome interplay with the CDO manager; believe me, these sort of people really do exist!
We now take a big step forward in our money and banking journey. “Safe” is in short supply; even if attained, “safe” can disappoint.
Debt instruments, even if issued by top quality credits such as the US government, can suddenly lose value if the interest rate environment goes sour (the Fed unexpectedly tightens by raising the fed funds target, for instance). And if you have to liquidate that asset sooner than planned, then that loss will have to be crystallised, maybe a large amount if you are sitting on long-dated bonds. It’s one manifestation of what we call market risk (there are other types we review later on in the course).
Knowing that in advance means that, before buying, investors will want higher yields the longer the maturity of the US government’s debt (both to cover for likely Fed tightening and for the anguish of living with such risks). Indeed, the US Treasury yield curve typically slopes upwards, unless there are recessionary rumours brewing.
Market risk is also present in the equity market. Recall that with equity there are no promises in the first place and that, with a high probability, prices will display roller-coaster features at times (specific, maybe even market, risk on steroids).
With debt, there are legally-binding promises but that does not mean that the borrower always delivers. Bonds can be unnervingly surprising at times! It’s what we call credit risk. We shall look at a number of examples by examining yield spreads against “gold-plated” US and German government paper. Banks, companies, even governments themselves can wobble – in terms of perception if not reality.
Managing risk is an important task, not just for banking professionals, but in our own daily lives. So we shall introduce concepts such as diversification (including hedging), together with supporting quantitative tools, notably covariances and correlations. We put theory into practice with a portfolio visualizer site. Other (free) tools you might find interesting include Fin Wiz and Sector SPDRs.
We have already learnt that money can take on many shapes and sizes. At any one time several monies can happily co-exist, even within a single jurisdiction. For most advanced economies, especially the US, top-quality money – the best that money can buy – is issued by the State (either coins, typically minted by the Government or bills and electronic deposits issued by the central bank). Such money is ultra-safe since it is directly supported by the promise of the State. If you can’t trust that promise then what hope is there?
However, we have also discovered that top-quality money is in relatively short supply. Most money, even as conventionally defined, is issued by the private sector – in the form of commercial bank deposits. These deposits are not quite as safe as high-powered money (aka the monetary base) especially if balances exceed the FDIC guarantee limit. However, for the many retail customers who are under the $250k limit, bank deposits are effectively a State promise and so, rationally, can be considered safe.
But for wholesale customers, such as cash-rich companies, there are risks in holding large pools of commercial bank deposits for which there is little compensation. US Treasury bills and bonds offer safe havens but, again, supply is insufficient to match demand and the yields on offer are skimpy.
This is the primary reason why shadow money – and the banking apparatus that supports it – is, and always has been, so large. The private creation of money-like instruments to supplement commercial bank deposits and government debt is legal, useful and huge. Across the three main sectors we focus on – commercial paper, money market mutual funds (MMMFs) and repos (repurchase agreements) – we shall find thriving multi-trillion dollar industries. Of course, the GFC dented shadow business, but it was not a killer blow.
Needless to say, private shadow money is not as safe as the monetary base. When the economy is in good shape shadow money is regarded as good as conventional money, arguably better since it offers higher interest rates. However, as brutally demonstrated during the GFC, the presumption of safety can be shattered in bad times leaving a sad pile of broken promises. Little wonder then that huge chunks of financial activity – built on “safe” quicksand – quickly tumbled into crisis.
In our introduction to shadow money we spend extra time talking about repurchase agreements (aka repos). One angle we shall probably not have time for is how, against the spirit – if not the letter – of accounting law, repos can be used to “window-dress” balance sheets; to make them look less leveraged than they really are.
Needless to say, Lehman Brothers provides a great example of what repos should NOT be used for – to mislead regulators, trading counterparties and investors. But they were used for that purpose, and Lehman’s sleight of hand was roundly condemned when the post-mortem took place. You can read the story here and here. This “loophole” was reportedly closed although suspicions often resurface about new forms of chicanery.
Our session on shadow money will also cover bonds – longer-term promises. Strictly speaking, bonds are not money – you cannot buy your weekly groceries with bonds. But a few agile moments with a smartphone could readily turn bonds into “cash” (market liquidity) or act as collateral for borrowing “cash” (funding liquidity). Bonds can reasonably be viewed as quasi-money and certainly play a leading role in the shadow money and banking world.
In dealing with money market instruments and bonds we need some technical expertise in calculating interest rates and yields. Along the way we learn about
the inverse relationship between asset prices and yields
the heightened price sensitivity of assets as duration (maturity, length of borrowing) increases
that a safe asset (the promise is kept) is not necessarily a risk-free asset; market risk can be especially painful for holders of long-term promises;
We shall use discounted cash flow (present value) methods to price credible promises. A key insight here is that a promised cash flow can be viewed as an income earning asset. That promise could start off as an OTC loan but it could also readily spawn the creation of an exchange-traded security. Mortgages provide an excellent example.
This, and our following session on risk, are amongst the most technical of the course. However, while some of the material is tricky, please persevere with it. The lessons learnt will be invaluable – not just for this course but for navigating your personal financial future!
In our preliminary discussions about banks and balance sheets we shall learn something new about money. Trust remains central, not least our trust, as bank customers, that electronic deposits are safe. And yet you may well feel that something fishy is going on. Banks appear to create money out of nothing. In a sense, because balance sheets balance, deposits (money) – liabilities of a commercial bank – are backed by assets, notably the loans that commercial banks make. But then those loans can be risky and banks are often locked into contracts that mean they cannot necessarily call in those loans at a moment’s notice. In contrast depositors can shift or withdraw their deposits very quickly. Deposits are meant to be safe and liquid. Loans are typically much less safe and illiquid. It makes money and banking seem like a form of medieval alchemy: a magical transformation of base metals into gold.
Well, you are right to feel uncomfortable. Money and banking is a form of alchemy except textbooks like to give it more “scientific” descriptions such as risk and maturity transformation. In fact, the former Governor of the Bank of England, Mervyn King, has written a book on the issue called “The End of Alchemy: Money, Banking and the Future of the Global Economy“. It is an excellent book and I highly recommend it. Your textbook authors, Cecchetti and Schoenholtz, also give the book high praise in their blog article, Making Banking Safe.
Our introductory session on money highlights a number of points, including
money as symbolic of civilisation: the dominance of voluntary, commercial exchange over violence; the emergence of respect for the rule of law and property rights
the State (democratic or autocratic) has always played a huge role in supporting the “moneyness” of money
money is typically an IOU (though there are exceptions) and so fundamentally depends on trust
By way of illustration, a little-known ceremony in London – dating back to the 13th century – takes place each year. So, in addition to taking a look at the above video, check out the following references if you’re still not convinced that money is steeped in history and politics.
Needless to say, the lecture will cover more contemporary examples of how the State uses money and its supporting infrastructure not just to achieve core objectives such as financial and monetary stability but also to help enforce the law and pursue foreign policy.
Money comes in many shapes and sizes: physical or digital, privately or publicly issued; widely or narrowly available; and with transfer systems that can be centralised (“traceable” bank deposits) or decentralised (“anonymous” peer-to-peer bitcoins). Textbooks generally focus on money that is an asset for the holder with a corresponding liability somewhere else in the system (a central bank if it is dollar bills or a commercial bank if it is an electronic bank deposit).
However, popular interest – but not participation – is currently engaged by new, disruptive, quasi-money. Bitcoins, like many of their cryptocurrency rivals and other commodity-style moneys, are not the liability of anyone else. It can all get rather confusing. As such, I highly recommend you read a recently published article from the BIS (Bank for International Settlements) which contains some illuminating “flower” visualisations.
Money Flower: TaxonomyMoney Flower: Examples
The article also discusses
issues that central banks need to consider, should they decide to introduce their own cryptocurrencies
some key technical drawbacks with the blockchain system (which is just one type of distributed ledger technology)
Like any product, money has its price. Indeed we shall unveil four prices to choose from. One is the exchange rate and we shall take the opportunity to review currency markets and how not to get confused by foreign exchange quotations. As we look at the grand historical sweep of global currencies over millennia we shall see once more that power, politics and money are inextricably linked.
Welcome to London – still a top global financial centre, despite Brexit uncertainties. I look forward to meeting you all next week.
The world of Money & Banking remains as controversial, disruptive and surprising as ever. We are just over ten years on from the Lehman Bros bankruptcy; a defining moment in a defining period of 21st century history – the so-called Great Financial Crisis (GFC for short). As we shall discover, the impact on day-to-day finance is still very much with us and there are plausible concerns that another major shock could be around the corner.
Our course will touch on these and many other contemporary issues; placing them in historical and political context. I make no apologies in revisiting medieval, even earlier, periods to illustrate core concepts that remain deeply relevant. Politics also figure largely since governments, autocratic and democratic, work hand-in-hand with finance to maintain order and preserve power. As both Lenin and Keynes preached, debauching the currency is the quickest route to social revolution. While the media gets excited about Russian influence on election results, consider whether it matters compared with the power of the finance lobby.
Of course, I would be remiss not to balance the Arts with the Sciences. So there will also be some maths, psychology, statistics, and other technical analysis to help unravel underlying themes.
Do not worry if you have limited academic experience of finance and associated disciplines. It is not required as the course begins with basic principles before gearing up. Like a rollercoaster ride, the trip starts slow… teasing you for the fun to follow. So just keep riding, hold on to your seats and, above all, enjoy!
We start our first session with administrative issues which should take about 30-40 minutes:
course overview and syllabus
textbook and online resources
attendance, registers & class etiquette
office hours
session formats & student presentations
assessment and grading
The remainder of Session 1 will focus on the Financial System and its three key components: Institutions, Instruments and Markets.
Finance offers indispensable contributions to society and the economy:
running the payments system
matching lenders and borrowers
lifetime wealth management
dealing with risk
For these reasons, money, other forms of debt, banks and financial markets have been essential building blocks of civilisation for millennia. Finance, including derivatives, go back to pre-Christian times and plays a central role in the wealth of nations and the rise in living standards. Financial revolutions generally preceded Europe’s industrial revolutions over two centuries ago. It was finance that built, and destroyed, great Empires. Just over a decade ago, a bank won the Nobel peace prize just before the global financial system started plunging into meltdown.
Finance is ingrained in human culture – art, drama, literature, old and new. Are we impressed that “A Lannister always pays his debts“? And what are your thoughts about Gordon Gekko, 1980s Hollywood villain, who infamously preached that greed is good?
Modern society needs finance; we cannot exist without it. But we have to take the rough with the smooth. Finance can go horribly wrong; history is littered with systemic crises. The GFC is just the latest, but surely not the last, example of catastrophic global underperformance.
The main conceptual learning objectives for this sessionare to flag several key themes that will be examined more deeply in future meetings:
Crises are irregular, tough to predict and, all too often, chaotic – displaying unnerving, amplifying doom loops
Risk is omnipresent and is aggravated by globalisation and innovation; it takes on many guises. Risk is generally disliked and, even if recognised, is not always properly managed
Wall Street is Main Street and vice versa; the worlds of finance and the “real” economy are inseparable, especially when it comes to real estate
Finance is a force for both good and evil. Society needs finance but, too often, we overindulge and succumb to financialisation
Banks (and related financial companies) do not always add value; sometimes they just reshuffle existing assets and, in so doing, can actually destroy value
Modern finance reflects the Jeckyll & Hyde impacts of globalisation, regulatory overhauls and technological innovation; in our digital age, value is even harder to establish, exacerbating volatility and risk
Banks (and money) can take many different forms; simple or complex, transparent or “shadowy”
Finance, old and modern, involves a mutually beneficial public-private partnership that can sometimes backfire
No specific technical skills will be introduced at this stage although students will be expected to have a rough idea of so-called “safe” assets, the role of banks as producers (not simply intermediaries) and the nature of principal-agent problems.
For class prep, in addition to looking at the above video, I recommend this introduction from the Association for Financial Markets in Europe (AFME). Also take a look at this blog article about the connection between banks and nuclear reactors.
