Sunday, June 13, 2010

Finance: Some Very Basic Concepts

Part of struggling to understand what the financial crisis and financial reform are about includes struggling to understand the terminology. And not just complex and technical jargon, but basic concepts like a "bank." What is a bank, exactly? The most obvious answer is it's where you park your money to keep it safe, the the answer is more complex than that. Are Savings and Loans banks? What about credit unions? What about investments banks, which have the word "bank" in their name, but don't take deposits at all?


Paul Krugman offered a rough definition of banking in his book. A bank is an institution that borrows money to invest. Specifically, it promises its lenders that they can cash out fast, while making investments that are not easily liquidated. Such an arrangement is inherently unstable -- if too many lenders want to cash out at once, the bank cannot liquidate its investments fast enough to satisfy all of them. Panic and a bank run ensue. Since the experts don't agree on which financial institutions should or should not be called "banks," I will just refer to any institution that borrows to invest as a financial institution and refer to the ones that take deposits as commercial banks (a term sometimes used to distinguish them from investment banks).


This led to the next very elementary question -- what is the difference between a lender and an investor. The distinction is straightforward enough at your neighborhood commercial bank, but it becomes less clear as you move deeper into the realm of high finance. Basically, though, a lender gives a financial institution money with a clear, contractual right to repayment on pre-determined terms that are independent of the institution's fortunes. In other words, a lender (in theory, at least) gets no less if the borrower is doing poorly and no more if the borrower is doing well. Investors, in effect, get what is left when borrowers are paid off, but they have no right to any specific amount. Investors reap the profits in good times and bear the losses in bad times. If the institution fails, lenders recover what they can in bankruptcy proceedings, and investors get nothing at all. Investors, in short, are the ones who bear the risks.

For a commercial bank the distinction is obvious. Depositors are the lenders. A bank account is, in effect, a loan to the bank that can be called in at any time, in whole or in any part. A bank account is listed on the bank's balance sheet as a liability because the depositor can withdraw or close it any time, although the cash in the account is, of course, an asset.

In an insurance company, policy holders are lenders who can call in their loans only if they have a misfortune.

In a non-financial corporation, stockholders are investors and bond holders are lenders. Bonds pay interest on pre-determined terms. Stocks pay dividends that depend entirely on the profitability of the corporation.

And then there is high finance. Most accounts of high finance focus on the sorts of investments they make -- complex and risky investments that commercial banks are barred from making. What I am still struggling to understand is where high finance gets its funding, i.e., who it borrows from to make its investments. The answer (so far as I can tell) is that various high finance institutions borrow from each other, sort of like taking in each other's wash.

Again, I understand what happens when there is a run on a commercial bank. Depositors all want their money back at the same time. The bank doesn't have (most of) it in the vault and can only pay a few of them. The bank fails. Most of the depositors lose their money. The bank is no longer available to make loans. (And, although this does not get so much attention, presumably anyone who owes the bank is off the hook). Worse still, a single bank run can lead to a run of runs. The damage to the larger economy can be devastating. Recessions can come from many causes, but, so far as I can tell, true depressions come from some sort of malfunction in the finance system.

It was to prevent such an outcome that deposit insurance was instituted, and it was highly successful. Runs on commercial banks ceased. The industrial world, at least, stopped having depressions, and until the current crisis, even threats of depression. But, as I understand it, in the latest crisis a series of non-depository financial institutions suffered runs as their lenders (known as counterparties) all started calling loans at the same time.

What I am still struggling to understand is who those counterparties were, and what happens to the finance system when high finance institutions suffer runs.

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