Boğaziçi University AD487-Current Trends in Selected Industries

September 20, 2017

Banking: A Soft Introduction

Presenter: Eren OCAKVERDİ Research and Analytics Consultant eren.ocakverdi@yapikredi.com.tr

Let’s put things into a perspective!

Financial system is like plumbing or electrical grid.

When it’s working well, we pay little or no attention...

Financial Institutions and Banking

• Financial Intermediaries: institutions that borrow funds from people who have saved and make loans to other people:

Banks: accept deposits and make loans

Other Financial Institutions: insurance companies, finance companies, pension funds, mutual funds and investment banks

• Financial Innovation: the development of new products and services (i.e. the advent of the information age and e-finance)

• If an individual wanted to make a loan to IBM or General motors, for example, he or she would not go directly to the president of the company and offer a loan.

• Instead, he or she would lend to such companies indirectly through financial intermediaries.

Function of Financial Markets

• Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds

• Direct finance: borrowers borrow funds directly from lenders in financial markets by selling them securities.

• Promotes economic efficiency by producing an efficient allocation of capital, which increases production

• Directly improve the well-being of consumers by allowing them to time purchases better

Function of Financial Markets

Lenders-Savers:

1- Households

2- Business firms

3- Government

4- Foreigners

Borrowers-Spenders:

1- Business firms

2- Government

3- Households

4- Foreigners

Funds Financial Markets Funds

DIRECT FINANCE

Financial Intermediaries

INDIRECT FINANCE

Funds Funds

Fun

ds

Sources of External Funds for Nonfinancial Businesses

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Bank Loans Nonbank loans Bonds Stock

76%

10% 7% 8%

78%

8% 9% 5%

56%

18% 15%

12%

18%

38%

32%

11%

Germany

Japan

Canada

United States

Some Basic Facts

• Stocks are NOT the most important sources of external financing for businesses

• Issuing marketable debt and equity securities is NOT the primary way in which businesses finance their operations

• INDIRECT FINANCE is many times more important than direct finance

• Financial intermediaries, particularly BANKS, are the most important source of external funds used to finance businesses.

• The financial system is among the most heavily regulated sectors of the economy

• Only large, well-established corporations have easy access to securities markets to finance their activities.

Function of financial intermediaries: Indirect Finance • Lower transaction costs (i.e. time and money spent).

• Deal with asymmetric information problems.

• As providers of indirect finance, banks want to make loans only to the highest-quality borrowers.

• When they do their job correctly, investment and economic growth increase at the same time that they reduce investment risk and economic volatility.

• Reduce the exposure of investors to risk

– Economies of scale (reduction by increasing the size)

– Risk Sharing (i.e. asset transformation: risky assets are turned into safer assets for investors)

– Diversification (collection of assets whose returns do not always move together)

Volatility of a large portfolio

• Volatility declines as the number of stocks/assets grows.

• But even for a very large portfolio systematic risk remains.

Distribution of annual returns

Not always a bed of roses!

• Asymmetric information: one party often does not know enough about the other party to make accurate decisions.

• This inequality may result in a “financial repression” created by an institutional environment characterized by:

• Poor system of property rights (lenders are unable to use collateral efficiently in the case of borrowers’ default)

• Poor legal system (difficult for lenders to enforce restrictive covenants that specify certain activities that the borrower can or cannot engage in)

• Weak accounting standards (less access to good information)

• Government intervention through directed credit programs and state owned banks (setting interest rates at artificially low levels for certain types of loans, by creating development finance institutions to make specific types of loans, or by directing existing institutions to lend to certain entities).

How banks deal with information asymmetry?

• Before the transaction: try to avoid selecting the risky borrower (i.e. adverse selection).

• After the transaction: ensure borrower will not engage in activities that will prevent him/her to repay the loan (moral hazard).

– Potential bad credit risk are the ones who most actively seek out loans.

– So they gather information about potential borrower!

• As a result, banks allow “small” savers and borrowers to benefit from the existence of financial markets.

– Once borrowers have obtained a loan, they make take on big risks because it’s someone else’s money.

– So they sign a contract with restrictive covenants loan!

Then what happened in the U.S. Subprime Crisis?

Source: Scene from the movie «Too Big to Fail (2011)»

Henry Paulson, Secretary of the Treasury then, and his team are discussing how to make a press call explaining the reason behind the Troubled Asset Relief Plan. That is, Treasury to spend $700 billion purchasing subprime mortgage assets from troubled financial institutions or to inject capital into these institutions...

Credibility loss in the aftermath...

Source: Billio, Monica, Lo, Andrew W., Getmansky, Mila and Pelizzon, Loriana, 2011. «Econometric Measures of Connectedness and Systemic Risk in the Finance and Insurance Sectors». MIT Sloan Research Paper No. 4774-10.

1994-1996 period 2006-2008 period

583 connections 1244 connections

This is why it turned into a systemic crisis...

Source: IMF World Economic Outlook, April 2014.

Probability of a banking/currency crisis

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

Overvaluation No overvaluation

Low credit expansion High credit expansion

Dynamics of financial crises in emerging markets

• Emerging market economies are particularly vulnerable to financial crises because:

• Politicians and prudential supervisors (agents) are ultimately protectors of voters-taxpayers (principals)

• They should NOT encourage powerful domestic business interests to pervert the financial liberalization process

– they are in an earlier stage of market development that have recently opened up to the flow of goods, services, and capital from the rest of the world

• The lending boom ends in a lending crash when:

– prudential regulation and supervision to limit excessive risk taking were weak.

• Significant loan losses emerge from long periods of risky lending, weakening bank balance sheets and prompting banks to cut back on lending.

Dynamics of financial crises in emerging markets

• Stage one: Initiation of Financial Crisis.

– Path one: mismanagement of financial liberalization/globalization:

– Path two: severe fiscal imbalances:

• Weak supervision and lack of expertise leads to a lending boom.

• Domestic banks borrow from foreign banks.

• Fixed exchange rates give a sense of lower risk.

• Banks play a more important role in emerging market economies, since securities markets are not well developed yet.

– Additional factors:

• Governments in need of funds sometimes force banks to buy government debt.

• When government debt loses value, banks lose and their net worth decreases

• Increase in interest rates (from abroad)

• Asset price decrease

• Uncertainty linked to unstable political systems

Dynamics of financial crises in emerging markets

• Stage two: Currency crisis

– Deterioration of bank balance sheets triggers currency crises:

– How severe fiscal imbalances triggers currency crises:

• Government cannot raise interest rates (doing so forces banks into insolvency)…

• … and speculators expect a devaluation.

• Stage three: Full-Fledged Financial Crisis:

• Foreign and domestic investors sell the domestic currency.

The debt burden in terms of domestic currency increases (net worth decreases).

Increase in expected and actual inflation reduces firms’ cash flow.

Banks are more likely to fail:

• Individuals are less able to pay off their debts (value of assets fall).

• Debt denominated in foreign currency increases (value of liabilities increase).

Sequence of Events in EM Financial Crises

Turkish Experience (crisis of 2001)

Internal & External Conditons

• Increase in political risks

• Increase in FX demand

• Capital outflows

• Difficulty in internal debt sustainability

• Credibility loss of prevailing economic program

Macroeconomic effects

• Rising interest rates

• Significant depreciation of Turkish lira

• Rising tendency of inflation

• Slowdown of real economy

Banking sector effects

• Increase in funding loss due to liquidity and interest rate risk

• Securities portfolio losses

• Losses due to FX short positions

• Weakening asset quality and increase in credit risk

Source: BRSA, 2010. «From Crisis to Financial Stability (Turkey Experience)», Working paper, 3rd ed. www.bddk.gov.tr

Core functions of a bank

Source: ATKearney Report (2014) «Banking on Our Future: Framing a Vision for the Australian Banking Industry», Figure 1.

Banks need to balance competing objectives

Source: ATKearney Report (2014) «Banking on Our Future: Framing a Vision for the Australian Banking Industry», Figure 2.

Let’s get our hands dirty!

-8

-6

-4

-2

0

2

4

6

8

10

12

-8

-6

-4

-2

0

2

4

6

8

10

12

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

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19

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19

99

20

00

20

01

20

02

20

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05

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09

20

10

20

11

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20

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20

14

20

15

20

16

20

17

20

18

20

19

20

20

20

21

20

22

Developing Economies

Advanced economies

World

Turkey

Source: IMF World Economic Outlook, April 2017

(%) (%)

Historical economic growth rates

Historical inflation rates

0

1

2

3

4

5

6

7

8

9

10

11

0

1

2

3

4

5

6

7

8

9

10

11

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

20

17

20

18

20

19

20

20

20

21

20

22

Advanced economies

Developing economies

World

Turkey

Source: IMF World Economic Outlook, April 2017

(%) (%)

Inputs

Loan amount 50,000 ₺

Mean interest rate 12%

Std dev interest rate 1%

Assuming interest rates are independent

Year 1 2 3 4 5 6 7 8 9 10

Interest rate 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0%

Remaining principal 50,000 ₺ 47,500 ₺ 45,000 ₺ 42,500 ₺ 40,000 ₺ 37,500 ₺ 35,000 ₺ 32,500 ₺ 30,000 ₺ 27,500 ₺

Principal payment 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺

Interest payment 6,000 ₺ 5,700 ₺ 5,400 ₺ 5,100 ₺ 4,800 ₺ 4,500 ₺ 4,200 ₺ 3,900 ₺ 3,600 ₺ 3,300 ₺

Net payment 8,500 ₺ 8,200 ₺ 7,900 ₺ 7,600 ₺ 7,300 ₺ 7,000 ₺ 6,700 ₺ 6,400 ₺ 6,100 ₺ 5,800 ₺

Total payment 71,500 ₺

Assuming interest rates follow random walk

Year 1 2 3 4 5 6 7 8 9 10

Interest rate 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0%

Remaining principal 50,000 ₺ 47,500 ₺ 45,000 ₺ 42,500 ₺ 40,000 ₺ 37,500 ₺ 35,000 ₺ 32,500 ₺ 30,000 ₺ 27,500 ₺

Principal payment 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺ 2,500 ₺

Interest payment 6,000 ₺ 5,700 ₺ 5,400 ₺ 5,100 ₺ 4,800 ₺ 4,500 ₺ 4,200 ₺ 3,900 ₺ 3,600 ₺ 3,300 ₺

Net payment 8,500 ₺ 8,200 ₺ 7,900 ₺ 7,600 ₺ 7,300 ₺ 7,000 ₺ 6,700 ₺ 6,400 ₺ 6,100 ₺ 5,800 ₺

Total payment 71,500 ₺

Simulating interest rates

Simulating exchange rates

Critical target (end of 5th year) 250,000 ₺

Distributional parameters Initial val. Growth Real Interest RateExchange RateInflation

Unknowns Param.-1 Param.-2 Param.-3 Average 4.0% 2.0% 3.00 8.0%

Initial cost of investment $100,000 $100,000 $100,000 $100,000 Std. Dev. 0.5% 0.2% 0.20 1.0%

First year's return $60,000 $60,000 $60,000 $60,000

Annual fixed cost $25,000 $25,000 $25,000 $25,000

Annual variable cost (ratio) 50.0% 50.0% 0.0%

Years 0 1 2 3 4 5 6 7 8 9 10

Firm's economic elasticity 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5

Economic growth (real) 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0%

Inflation 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%

Real interest rate (discount rate) 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0%

Exchange rate ($/TL) 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00

Cash Flow

Years 0 1 2 3 4 5 6 7 8 9 10

Return $60,000 $68,688 $78,634 $90,020 $103,055 $117,978 $135,061 $154,617 $177,006 $202,637

Fixed cost $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000

Variable cost $30,000 $34,344 $39,317 $45,010 $51,528 $58,989 $67,530 $77,309 $88,503 $101,318

Cash flow ($100,000) $5,000 $9,344 $14,317 $20,010 $26,528 $33,989 $42,530 $52,309 $63,503 $76,318

Output Summary results CorrelationsGrowth Inflation Exch. Rate

Net Present Value (NPV) 219,639 ₺ Average NPV 245,851 ₺ Growth 1.0

Total cash as of 5th year 283,549 ₺ Probability of a negative NPV 22.9% Inflation -0.5 1.0

Average cash as of 5th year 294,435 ₺ Exch. Rate 0.0 0.6 1.0

Probability of missing the target 38.2%

Conditional value at risk -255,249 ₺

Simulating cash flows

Textbook references:

• Frederic S. Mishkin, 2013. «The Economics of Money, Banking and Financial Markets». 10th ed. Chapters 1, 2, 8, 9 and 10.

• Cecchetti, S. G. and Schoenholtz, K. L. (2014). «Money, Banking and Financial Markets». 4th ed. Chapters 11.

Suggested reading: • Laeven, L. And Valencia Fabian. (2012). «Systemic Banking Crises

Database: An Update». IMF Working Paper No. 12/163.

APPENDIX

Some Basic Concepts

• Adverse Selection:

– If quality cannot be assessed, the buyer is willing to pay at most a price that reflects the average quality

– Sellers of good quality items will NOT want to sell at the price for average quality

– The buyer will decide not to buy at all because all that is left in the market is poor quality items

– The managers in control (the agents) may act in their own interest rather than in the interest of the stockholder-owners (the principals) because the managers have less incentive to maximize profits than the stockholder-owners do.

– Borrowers have incentives to take on projects that are riskier than the lenders would like. This prevents the borrower from paying back the loan.

• Moral Hazard:

Efficient Market Hypothesis

• Security prices reflect all available information.

• A trader can not make a profit by analyzing either

– past price information (weak)

– public information

– private information (strong)

• “There is no other proposition in economics which has more solid empirical evidence supporting it than the EMH” (Jensen, 1978) – Nobel prizes for Fama, Shiller (2013)

1-35

1-36

Newton’s South Sea investment “I can calculate the movement of stars, but not the madness of men”

Source: http://www.telegraph.co.uk/finance/personalfinance/investing/10848995/How-not-to-invest-like-Sir-Isaac-Newton.html

How macroeconomy works?

Source: Valentino Piana, www.economicswebinstitute.org

Income

Consumption Employment

Unemployment

Wages

Price level

Savings

Taxes

Public Expenditures

Exports

Imports Investment

Real Interest Rate

Nominal Money Supply

Real Money Supply

Nominal Exchange

Rate

Real Exchange

Rate

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