CITY INSTITUTIONS - financial services industry
Very rough notes by Chris Horrie
Investment Banking (Sell Side) – raising capital by selling shares, preparing companies for floatation of the stock exchange
Assessment Management (Buy Side) – also known as stock brokers – value companies, forecast profits and share price movements.
Insurance / Hedging companies (eg Lloyds) – selling commercial risk in a way similar to selling debt.
Currency Trading (divisions of the banks and commodity traders)
Central Bank and Discount Houses – government bonds
Retail Banks (including most building societies)
Mutuals – remaining building societies and Co-Op bank (highly regulated on CCR, etc – no speculative outside investments). Ethical.
INSTITUTIONS
Financial Services Authority (regulator)
Bank of England (central bank – lender of last resort – fixes interest rates, controls the money supply – bonds, etc.
Treasury (Finance ministry) – Chancellor of the Exchequer – overall political direction. Also FISCAL policy – ability to control levels of taxation which undefrly ability to issue bonds and accrue government debt (national debt – in the UK dates back to the Napoleonic Wars). National Debt is not a bad thing (Keynesian economics) nor is a bad thing (Adam Smith neo-classical economics). Depends on economic theory.
Keynesians now got the upper hand. Neo-liberalism discfredited. If try to pay off national debt now the entire economy would collapse. We now have unprecedented levels of debt.
MARKETS
The London Stock Exchange - trades shares and government bonds
///NB company law – AGMs, share prices, P/E ratios – Financial Times]///
‘Bond market’ notional arrangements between specialist divisions of the merchant banks. Basically they discount government debt.
AIM – Alternative Investment Market
Commodity Trading – LIFE (London International Futures Market)
Other smaller specialist commodity exchanges (eg Baltic Exchange)
THE CITY
This is an industry which produces money (or ‘debt’ as you might think about it) – the financial services industry - One of the largest employers in the UK (even after credit crunch).
How do banks work?
Assets (in case of the central bank, The Bank of England - gold reserves) in other cases tangible like land, property, cash or abstract like contracts, commodity futures and options, mortgages, government bonds, etc.
Credit creation ratio (key concept)
For each £100 of assets bank will create accounts of x10 = £1,000 (CCR = 10)
Thus out of ‘nothing’ the bank has created £900.
Can lend this £900 at say 10 percent interest = £90 profit.
CCR works on the principle that at any one time nobody will come and take out more than the CCR proportion of their bank balance (even if that bank balance is debt created by the bank – eg an overdraft. So in this example the bank will be OK so long as the people it has made 9x100 loans too do not take out on average more than 10 percent of their balance (£10) at any given time because 9x10 = £90 = the bank actually has that in its values (or liquid assets such as bonds, mortgages) etc.
STOCK EXCHANGE AND PROFIT MOTIVE
Banks are companies like any other (except Bank of England). By law must return maximum value to shareholders (within framework of banking regulation – The Financial Services Authority – FSA – key institution.
HIGH CCR = High profits/ low security (for shareholders)
LOW CCR = Lower profits / higher security (for shareholders)
In 1990s demand for bank shares on the stock exchange (profitability of the company will tend to increase the price of shares (Stock Exchange – a separate but related set of processes and institutions.
Fanny and Freddy May and Northern Rock ‘type’ banks (these are not the actual facts).
- Low quality/ inflated assets (such as IOU mortgages from very poor people). These were overvalued by lax accounting conventions (re-valuing assets, and then borrowing against these assets – ENRON style). You had an IOU which was really worth £10, but you said it was worth £1000. (asset price inflation – eg property, art, footballers, etc. Vast accountant-led upward revaluation of everything.
- With a CCR of 100 your original £10 of real value (inflated to book value of £100) is now worth 10,000. You have “created” £9,999 value from your £10 investment just because you have a big building with smoked glass windows, have appeared on ‘The Apprentice’ have a fountain the reception of your office (possibly solid fake gold) and have enormous granite blocks with your name engraved on them in the middle of town. Financial press generally very bad, going along with the hype – or actually profiting (eg City Slickers). CF – Bonfire of the Vanities.
- You can lend the money to yet more derelicts (eg the government of Mexico or Argentina or Zimbabwe somewhere like that). In more corrupt cases – Nigeria - these loans will boomerang straight back to banks in London – eg BCCI and ENRON – so basically the banks are lending money they have created to themselves using some third world country as a ‘cut out’.
- The 90s was a period of relatively high real-term interest rates (set by the central bank – as part of the war on [price and wage] inflation. So you are getting another 10 percent income from the £9,999 you created – so the total increase in vale (profit) is £11,000 per £10 of real value or per £100 of loans on the book.
- Your bank is now superprofitable and everyone wants your shares (dividends) and also probably wants to have sex with you (If ‘Bonfire of the Vanities’ is to be believed). So your £100 shares are on sale on the stock market and go up to £1,000 (each). Your bank has probably issued one million shares – so there’s another profit of £900 million right there. You can use all his new asset value to lend yet more money (LEVERAGE). The problem becomes where to find people who are prepared to borrow yet more money. It becomes sort of unpatriotic not to be in massive debt.
- People buy the shares partly because they want the dividends, but also bcause they too are ASSETS. So a second bank which holds your shares can revalue its assets upwards as well (remember this is all based on giving a £100,000 mortgage to a person who could only ever repay £10 – if that! - ~TOXIC DEBT).
- The second bank also becomes superprofitable based on your shares (which are also basically junk – over-valued by 1000 percent). YOU buy some of their shares. You claim their shares as assets against which can make loans (at high rates of interest). The cycle of asset inflation, lending, profitability and increasing share price (bull market) continues until a turning point is reached – ‘credit crunch’.
ANATOMY OF A CREDIT CRUNCH
- Mass defaulting on toxic mortgages – Freddy May and Fanny May. Reveals the very poor quality of underlying assets in many banks.
- Toxic debt widely spread - many banks had bought the debt. It was very profitable because of high nominal interest rates, and ease of discount.
[selling debt – how it works. Bank loans £1000 with a high interest rate so that £20,000 is paid back. But the payments are made at £20 a year for 1,000 years, so the terms are very attractive to the borrower. The bank makes the loan and has a contract to receive £20,000, but will only get £20 this year. So can sell on the debt (discounting) to a second bank. So the contract/mortgage that will yield £20,000 is sold for £10,000 cash now (heavy discounting). The bank that made the original loan gets £10,000 this year for making a £1,000 loan. The second bank may then revalue the mortgage up and sell it on straight away for £15,000 (instance profit of £5000); the third bank who might sell it for 17,000 then a fourth for 18,000… and so on right the way back to just a few pence short of the actual £20,000 – this process of buying and selling debt creates all these pockets of value and profit from ‘thin air’ every time it happens. In a further complication the debt was ‘chopped up’ into bundles, and packaged with bit of more reliable debt (like UK government bonds). The idea was that if you spread the toxic debt thinly enough and mixed it with real assets you would be OK – and for a decade it worked (sort of).
- RETAIL BANKS – Northern Rock – extended themselves with huge CCR secured on vastly discounted debt bought from the states. RUN ON THE BANK – what happens when the CCR goes into reverse – people turn up and take out the their money. The bank will not have that money and will literally have to pull down the shutters. Depositors will lose all their money – unless another bank bails them out. But there is an element of panic about this (media again plays a role) – so the same thing is happening to all the banks. Government may have to bail out the banks – The Lender of Last Resort (Bank of England) can borrow on world money markets (eg China, Saudi, Dubai) to shore up the system. Will not have to extinguish all debt, but will need to restore confidence.
- Loss of forward momentum means that banking sector is very UNprofitable, bank shares crash, brings down he stock exchange as a whole (all shares fall in price) – suddenly assets are being DEVALUED down again, until some sort of ‘real world/ use value’ of assets is reached. In the meantime millions of jobs and businesses sustained by the ‘cheap money’ that was easily available in the boom disappear. Unemployment, recession possible long term economic depression.