A Financial Crisis in the Making Part III
Fact 2: See “bottom-up”
One very important lesson from this financial crisis is that we cannot understand the problem by simply analyzing it “from top to bottom”. It is possible that there have been some of the same underlying factors that have contributed both to the financial crisis we are in now and to the US trade deficit. As we pointed out, the trade deficit, the budget deficit or the US government debt have probably also made the country less able to cope with the crisis when it occurred. However, there is little to suggest that the crisis was triggered by any of these overarching variables.
To better understand what has happened, we must instead approach the problem “from the bottom up” and try to understand what is different about the international financial markets today compared to before, why financial institutions both now and in the past are fundamentally unstable and based on trust, and what could be the consequences of that trust now seeming to be gone.
Facts 3 Banks and financial institutions: based on trust. The interbank market
All banks and financial institutions are fundamentally unstable and at the same time based on trust . Giant institutions such as Citibank and our local savings bank have this in common. The reason for the instability is that the loans are repaid over many years, while depositors have the opportunity to withdraw their money almost immediately.
According to SUNGLASSESWILL, banks and other financial institutions are intermediaries between depositors, who prefer to put money in accounts where they can withdraw them whenever they want, and borrowers, who prefer loans that are repaid over many years.
In normal times , the bank expects that only a small fraction of all the capital it manages will be withdrawn – even though all depositors have the right to withdraw their deposit at any time. Thus, a bank can issue loans with a long time horizon. Within a short period of time, it only needs relatively small amounts of cash on hand to pay some depositors who want to withdraw money.
In more abnormal times, however: If all depositors lose confidence in their bank and try to withdraw the money from their accounts at the same time – so-called “bank runs” – a bank will quickly run out of money and long before it is able to pay everyone depositors. The bank will go bankrupt. Even well-run banks are vulnerable in such situations. Then it does not matter whether the banks’ long-term loans are likely to prove profitable. If enough depositors expect (cf. psychology) that other depositors will withdraw their money, it only makes sense to run to the bank to be first in the queue of those who want to withdraw their money.
If the state guarantees that a bank will always have cash that it can pay out, people will always have confidence in the bank and bank runs will hardly occur. If the state guarantees the banks, it raises another problem with so-called ” behavioral risk “, namely that the management of the banks may want to enter into much more risky projects than they would otherwise. The idea will be: “The state will save us in the end.” Today’s bank regulation is therefore a trade-off between these conditions: ensuring financial stability without giving the management of the banks the wrong incentives.
We also find financial instability in the so-called interbank market . Banks lend to and from each other all the time, both nationally and internationally. In this way, the banks are also merged into a global financial network . In recent months, banks have become uncertain about each other’s solvency, and this market has shrunk sharply.
Facts 4 Securitization – securitization
If a bank or financial institution lends to many borrowers, e.g. to a neighborhood in Pittsburgh, Pennsylvania, the repayment rate on their loans will depend very heavily on the state of the economy in that particular area. In order to reduce the risk that a financial institution faced, and thus be able to lend more money on more favorable terms for customers, loans were put together into a security – so-called securitization – and resold.
Investors could then buy securities that were composed of loans from different parts of the country. Because the return on these would not depend on economic conditions that were very local, to e.g. Pittsburgh, the overall risk would be lower. Securities that were composed of mortgages only were often called mortage backed securities.
Facts 5 About derivatives
Derivatives are a security where the price is derived from underlying factors such as exchange rates, commodities, weather, etc. In March, a farmer in the Midwest may want to secure himself by buying the right to sell his crop to an investor and then at a predetermined price. Farmer and investor enter into a contract, almost a bet on the weather until September and the size of the crop.
If the price of a tonne of wheat in September exceeds the predetermined price, the gain goes to the investor (and the farmer has lost money). If the actual market price in September is lower, the investor has lost money and the farmer can breathe a sigh of relief. He can be happy that he had bought insurance against the uncertainty that the weather and world market prices constitute. Between March and September, the original agreement may have been resold several times.