Category: investing

“Panics do not destroy capital, they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works”, John Stuart Mill

Overviews on crisis

Crisis tends to only be obvious in hindsight. People tend to be biased towards optimism even in the darkest times.

Crisis are generally triggered by a momentary lack of liquidity which leads to  a whole cascade of events. This sends the entire system into a negative tail spin. A loss of trust in the system is the fundamental problem.

Types of crisis

• Banking crisis:
  • usually triggered by rapid deregulation leading to excessive levels of volatility within system
  • A single bank or the entire banking system experiencing a shortfall of liquidity which deteriorates into a massive bank run.
  • takes place before financial crisis
  • reaches highest point after financial crisis
• Financial crisis
  • country whose currency is not a reserve currency experiencing a shortfall of liquidity triggering off rapid exit of funds trying to avoid the negative currency exchange dip
• Twin crisis
  • when both bank crisis and financial crisis occur together resulting in cross feeding.
  • economic fundamentals are deteriorating in periods preceding twin crisis

Bank failure cause by banking crisis

• Quality of management plays a very important role in averting such crisis
• If bank is too big to fail
  • government will attempt to step in.
  • To restore trust
  • Relatively rare
• Smaller banks
  • will get absorbed by larger banks
• government interventions
  • when seen as too ready to step in will encourage moral hazard
  • results in banks taking excessive risk
  • want the funds to restore liquidity to come as much as possible from the private

Indicators for banking crisis

It is generally difficult to assess banks due to information asymmetry. Banks and government will want to delay the release of bad news to prevent deterioration of an already bad condition

Spreading the financial statements across different banks will help analysis risk

• Leading indicator:
  • Non-performing loans/assets as a percentage to total loans/assets
  • Non-performing loans as ratio to loan-loss reserves
• Lagging indicator: net interest income falls

Risk assessment method

• CAMEL model
  • Capital
  • Asset quality
  • Management
  • Earnings
  • Liquidity

Roles of Banks

Generalfunctions

• Hubs of financial networks that connect supply and demand for money
• Intermediary to smooth out friction in the flow of money
• Spread risk of loaning money
• Ease of liquidity
• Securitization to move loans off balance sheets
• Underwriting

Special functions

• Support national payment system
• Providing backup liquidity to non-banks
• transmission belt for monetary policy

Types of Banks

• Large banks – extensive network able to pull in consumer deposits at relatively low cost
• regional banks – has deep relationships with local territory and is able to meet the needs of local business better than large banks

Types of capital

• Consumer deposits – very sticky but small in amount
• Commercial deposits – very volatile but large in amount

Types of banking instruments

• Negotiable Certificate of Deposits
• Letters of Credit
• Derivatives
• Futures

Credit risk

The possibility of not getting the loan and interest back due to inability or unwillingness of the borrower. Assessed qualitative and quantitative elements

external factors

• sovereign risk
• cyclical risk

Components to model credit risk, a.k.a. Expected Loss

• PD – probability of default
• EAD – exposure at default: percentage of the amount of loan that will be affected by a default event
• LDG – loss given default
• Time horizon – the longer the time horizon the more likely the default

Risk assessment method

• general – Value at Risk (VaR) model
• fixed income analysis – fundamental and technical analysis

Currency risks triggered by sovereign/country risk

• policy lending – subsidizing industries through banking industry
• state-owned enterprises – encourages inefficiency

Components to consider

• GDP growth – a growing GDP will help buffer shocks to the system
• Fiscal deficit
• Monetary conditions
• Balance of trade

leading Indicators

• consumer confidence index
• manufacturers index
• money supply
• yield curve

lagging Indicators

• unemployment rate
• inventories to sale
• consumer credit to personal income

Risk management

• liquidity risk
• solvency risk
• market risk
• credit risk
• credit spread risk
• currency risk
• operational risk

Risk assessment method

• general – Value at Risk (VaR) model
• Stress test

Further Readings

• Managing banking risk, Eddie Cade
• The dollar crisis, Richard Duncan
• A failure of capitalism, Richard A Posner
• Bank restructuring, Andrew Sheng
• When genius failed, Roger Lowenstein
• Manias, panics and crashes, Charles P. Kindleberger and Robert Aliber