Liquidity & Capital Watch

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. It 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

  • excessive leverage
  • poor liquidity management
  • reduced lending standards
  • misinformation & misaligned incentives
  • flawed rocket science
  • regulatory weaknesses
  • limited legal powers to resolve failing banks
  • contagious networks
  • doom loops (positive feedback mechanisms)

If you have not done so already, I recommend dipping into The Economist’s survey of past financial crises or the wonderful book by Rogoff & Reinhart, This Time Is Different: Eight Centuries of Financial Follies. As the FT’s Martin Wolf has commented, “This Time Is Different” are the four most dangerous words in finance. 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!

SPH
22 Feb 2018

Risk Is All Around Us

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 shall look at 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 illustrates exactly that upward-sloping phenomenon.

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 standard” 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, Asset Correlation and Sector SPDRs.

SPH
15 Feb 2018

Repo 105

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 linger about continued chicanery.

SPH
10 Feb 2018

Money, Banking & Alchemy

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.

SPH
3 Feb 2018

Money Flowers

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: Taxonomy

Money Flower: Taxonomy

Money Flower: Examples

Money 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)

Ledgers

SPH
25 Jan 2018

Show Me the Money

Our introductory session on money highlights a number of points, including

  • the State (democratic or autocratic) has always played a huge role in supporting the “moneyness” of money
  • money is typically an IOU and so fundamentally depends on trust (although there are exceptions so make sure you also read my Money Flowers post)

By way of illustration, a little-known ceremony in London – dating back to the 13th century – takes place each year. So check out the following references if you’re still not convinced that money is steeped in history and politics.

History of the Trial of the Pyx, Royal Mint website
Have you ever seen a £1,000 coin? BBC News, 1 Feb 2017
Sampling Inspection and Quality Control: The Trial of the Pyx, University of Wisconsin, Feb 1976
SPH
25 Jan 2018

Welcome

Welcome to London – still the world’s top financial centre, despite Brexit uncertainties. I look forward to meeting you all next week.

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 significant contributions to society and the economy:

  1. payments system
  2. matching lenders and borrowers
  3. rearranging resources over time
  4. assisting with risk management

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 play a central role in the wealth of nations and the rise in living standards.

But finance can also go horribly wrong; history is littered with systemic crises. The Great Financial Crisis a decade ago is the latest, but surely not the last, example of catastrophic underperformance.

The main conceptual learning objectives for this session are to flag several key themes that will be examined more deeply in future meetings:

  • Finance is a mirror of the human condition; joyful and productive moments tainted by crises, cheats, irrationality, instability and illusions
  • Risk is omnipresent and comes in 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
  • Finance is a force for both good and evil; society needs finance but, too often, we overindulge
  • 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 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.

Stephen Hannah
18 Jan 2018