Back to the Basics - Lessons from the Current Market Turmoil

 Back to the Basics

With banks collapsing one after another, it is reminiscent of 2008 when the last major financial crisis hit us. For some, the recent bank runs might be a shock while others might shrug it off as “history repeats itself”. But the truth, like with most things, is somewhere in between. So, its time to look back into the basics to find out what went wrong and what can we do differently? I have tried to explain it in simple terms below:

Cash is King

In personal finance, people are always reminded to keep emergency cash (6-12 months) before venturing out into investments. So, why are financial institutions, and more broadly every company, not mandated to do so? While there are complex rules for financial institutions to determine how much cash to set aside (be it Risk Weighted Assets or High-Quality Liquid Assets), maybe it’s time to rethink “Idle cash is waste of money” adage more broadly and see what is required realistically? Should we mandate every company comply with Liquidity ratios (Liquidity Coverage Ratio, Net Stable Funding Ratio) so that they have enough cash to pay off their liabilities within one year?

Liquidity > Assets

Net Worth = Total Assets – Total Liabilities. Herein lies the issue as wealth is often defined by assets and liquidity does not feature in this equation! As this article eloquently puts it while analyzing why businesses fail, “..lack of capital will destroy your business over time, lack of liquidity will destroy it in a heartbeat..”

After 2008, even as focus slowly shifted from Capital to Liquidity for regulators, companies continued to take on clients with high/ ultra-high net worth without deeply evaluating their liquidity position, often cutting corners or turning a blind eye when they requested extended payment timelines or a higher margin call, which are typical liquidity red flags. So, should the equation that needs to be evaluated during client onboarding really be Real Worth = Total Liquid Assets – Total Current Liabilities or based on the Liquidity Coverage Ratio (LCR)?

Banking = Trust

Its not a coincidence that “bank” is a synonym for “trust”. I will bank on you only if I trust you. And it’s a big IF in the financial system as the recent events have shown us. Trust, like credibility, is very fickle. It takes years to build but can very quickly collapse on the back of one misdemeanor. Funnily, people can lose trust/ credibility based on perception rather than facts, which makes it very intriguing and not quantifiable. When people lose trust in a financial institution, it would simply collapse, however long legacy it may have. Lehman Brothers was around for 161 years and went poof within one.

Knee Jerk Reactions

Governments, Regulators and Market Participants like banks are in a symbiotic relationship. Regulators need to broadly align with the government policies and keep market participants happy. Government and Regulators are not silly, they monitor the market participants very closely, and have enough data points to know roughly the strength and issues plaguing each one. But their main role is to maintain the harmony within their ecosystem. However, when things go south, governments are pressured by the common man to take action, who then press the regulators to take action against errant market participants, so it is natural for there to be some knee jerk reactions.

 

Liquidity Component of Counterparty Risk

Lack of liquidity leads to failure of a lot of businesses, not just financial institutions. Going forward, it would be more prudent for the regulators to formally embed Liquidity Risk into Counterparty Risk ratings so that the common man can get factual information about the liquidity risk profile of a firm, rather than relying on misinformation and media coverage in order to from a perception of liquidity risk leading to bank runs and failure of financial institutions.

 

Technology View

As we move into the next phase of tightening regulations, it is important for organizations to better understand the holistic picture of their company as well as those of their clients. As a technologist, I seek to understand where the challenges are and what can be done to enable the business.  

 

Challenges

Compliance, Risk and Reporting are seen as a cost and a chore in most organizations. This cost-center mindset needs to change as the impact of not doing this right is life-or-death for the firm. These functions, in turn, should position themselves as business enablers, rather than policemen. This is easier said than done, as large organizations are often complex and no single person knows everything. This is where technology can help to de-mystify the landscape, consolidate the metrics, and highlight discrepancies.

The “cost” perception also leads to most firms using off-the-shelf vendor solutions for these areas to minimize operational costs. The vendor solutions are typically aligned to regulatory mandates as interpreted by the vendor. These solutions cater for Financial, Capital or Liquidity regulations, but do not offer a read-across and are not flexible enough to cater for every client’s individual needs. While they may offer some great benefits, they should not be relied upon as a one-stop-shop for all internal & external stakeholders. Often, the cost of change from one vendor to another is prohibitive, so organizations that are heavily reliant on specific vendor solutions tend to get stuck after a while.

Internal application landscape in major financial institutions is often complex, with legacy applications, disparate systems and convoluted data flows making it difficult to form a consolidated view across different metrics. Data duplication and multiple points of adjustments make it difficult to assess accuracy. Large organizations typically operate in silos with domain specific SMEs being non-fungible and therefore being unaware/ unable to assess impact on other functional areas. Businesses grapple with semi-automated solutions and are overwhelmed with operational priorities. Regulators have been moving towards element-based reporting (e.g., XBRL standard), but not at a consistent pace across the globe.

 

Solution Approach

Loosely connected architecture through APIs or micro-services would offer the most flexibility and reduced cost of change. This could be a great way to connect internal applications that produce different metrics as well as externally to clients, regulators and vendor solutions. Legacy applications/ services can be re-designed in a cost-effective manner to offer service endpoints. This approach also abstracts underlying complexity and allows flexibility of the technology stack being used for each application.

Liquidity solutions should be designed for message/ event-based processing, rather than batch processing, to improve turnaround times for crisis situations. For example, each cashflow or adjustment should be separately propagated through the application components/ calculation layers, rather than re-processing the entire set of cashflows as a batch. Each liquidity risk event could potentially then trigger a corresponding counterparty risk re-assessment based on appropriate factors, which could be tuned through a neural network.

An utopian concept would be to use Blockchain to encapsulate a single version of every transaction front-to-back, with each function appending details and calculated metrics as it traverses through the trade lifecycle. This would avoid data duplication and reconciliations. However, this approach would probably only be meaningful to new digital banks that start from scratch as it is not viable to re-engineer legacy applications this way.

Data virtualization tools can be used to provide an overarching management dashboard with actionable insights from various metrics to the business. Vendor solutions can be great reporting tools that offer last-mile connectivity to the regulators (e.g., submission mechanisms, final adjustments, review/ signoff workflows).

Way Forward

While everyone has an opinion about current events, its important to learn the lessons from the past and present to apply to the future. Stay close to your clients and investors, understand their needs, act on their concerns, be prompt and clear in your communication and most importantly, emphasize the role of Liquidity in making or breaking companies!

 

Arise, Awake and Stop not!

I have always believed in not crying about problems, but taking it as a challenge and to come up with solutions. Better still, see the opportunities arising from this peculiar situation and we can be better! I am not an expert, but I did think about it from a layman's perspective. With so many doom sayers around, what would it really take for the economy to really get back up on its feet?

For this, I went back to the Great Depression in 1929, which was the only comparable thing. Then, the Black Tuesday in October put a halt to the parties flung by merry men counting illusionary gains in the stock market. Same effects as today, Black October, trade decline, job losses, debt inflation went in a vicious circle. Back then, Roosevelt came and thought of a way out of the mess with the First New Deal, by providing more jobs mainly through construction work.

In this current scenario, with cities bursting with skyscrapers and unsold houses, construction sector could hardly provide any scope. So, whats the alternative. In my mind, the solution lies in the often neglected sectors and neglected things in a booming economy. Right now, lets do a Random Access analysis..

My Answer: Be Clean, Be Green, Be Seen

In the internet age, people are glued to the gadgets for our emotional needs. Our physical needs are catered by junk foods which are portable along with our laptops, mostly wrapped in cans and plastic. These are then mindlessly thrown into bins by decent souls and everywhere else by the majority. This means that in this cyberage, we often neglect their surroundings without even knowing about it. Wall-E, which some say is the best movie of 2008, brings it right to the point in the only way people seem to see things nowadays.. in animation.. Even cities boasting to be the cleanest place on earth, like Singapore, has seen its effects on its roadside pavements and inside lifts. Given the mess we have made in the last few decades, the Be Clean movement can create a lot of jobs in itself. And needless to say, it makes our home a much more liveable environment. So, Be Clean!

They has been a hightened concern about being green in the last few years, under the veil of global warming, but thats just one aspect. People do not realise anything until quite a few lives have been lost, because thats when the survival instincts kick in and they wanna set things right. As scientists have been screaming it could be too late before humanity wakes up to reality. But as always with scientists, they do not concur on anything and everyone has a different opinion. Some say global waming with screw things up, others say we are inbetween two ice ages and we are looking at a Global Freeze. Whatever it is, doesnt justify the way we are living right now. All bad things have good precincts, which even applies to atom bombs. Lets face it, the current situation is Do or Die! Given the current state of affairs, you would probably need a billion people on this movement to set right the impact of lousy decisions and lousy stuff our predecessors have done. In finance terms, increased jobs increased (green) resources, increased awareness and increased recovery. So, Be Green!

Its one of the ironies of life that its always easier in hindsight, but enough effort is not spent in foresight. In hindsight, people blame a lack of accountability, lack of responsibility and lack of due diligence, while forgetting the root cause of this round of recessions are due to lack of trust, which is the single pillar of the financial systems. Trust is linked to many factors and is as fragile as a girl's mood, which the world has realised in the harsh last few months. One of the most important things that trust is linked to is transparency. Complete transparency is scary, as the "Moments of Truth" show in Star World shows. However, better transparency is required to form the bond of trust in the first place! This is what the finance experts need to hold on to to revitalise the economy and the financial systems. Better transparency from firms allow it to "be seen" by the public and regulators, who would have better trust in investing in them. If they cant see what they are going into, they would just not go into it in a sinking economy. Bear Sterns to Satyam, things can be traced back to a lack of transparency. So, we need to ensure that companies are as transparent as they can be, and get in the regulations and enforcement as soon as possible to restore the public confidence in the system.

Lets start from the invidual by being clean, progress through our neighbourhood by being green and reach out to the masses by being seen!

I would love to see more solutions and opportunities arise from this situation we are in, rather than problems and cribbings.

Random Access
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My 2 cents on all things Finance - Part 3

I always believe its easier to understand through examples. Too many financial terms out there, but here are the basics:

Risk Averse - When you get all excited about bonds and shares and commodities, and you want to jump in and invest, but you dont.
Counterparty - Almost everyone whom you need to deal with.
Credit Risk - Risk that your friend will never return the Rs 100 that he owes you.
Market Risk - Risk that tomato will go upto Rs 30 a kilo suddenly due to some bad news on TV.
Counterparty Default - When your husband cheats on you.
Asset - Your house/ bike/ car
Depreciation - When your house looks "dull" compared to the new flat down the road.
Liability - The rent/ installments that you pay for your house/ bike/ car
Mortgage - When you proudly say its MY house, when the legal title is with the bank.
Capital - Your salary
Reserve - Fixed Deposit with your bank
Reserve Liquidity - Savings Deposit with your bank
IOU - Recurring Deposit with your bank
Accrued Interest - Interest from FD/ RD/ SB
Position - Current value of your house.
Unrealised profit - When your land cost shoots up and you are happy to have bought a house earlier.
Unrealised loss - When the laptop price slumps and you curse yourself for having bought a laptop last week.
Mark-to-Market - When you walk past a TV shop and see how much your TV costs currently.
Notional - Amount of bank loan that you always worry about, but never get to pay.
Know Your Client (KYC) - When you research all possible relatives and friends to see if the potential bridegroom is a "good boy" for your girl.
Guarantee - When you certify that the next door boy is "very good" when a potential father-in-law comes to check on him.
Collateral - The gold that a bride wears, that could go into a pawn shop when times go sour

Random Access
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My 2 cents on all things Finance - Part 2

The tough get tougher when the trough gets deeper.

Passing out of school brought about a whole new change for me, new country, new friends, new passions, new distractions, new way of life. It was all too overwhelming, and it took me a good two years to realise its just as challenging as my beloved Chennai. Money started disappearing faster than it has, all my life. Expenses became the norm of life. I spent everyday, my "own" money. Its enormous risk spending money that you did not earn. And one fine day, it all disappeared. I had to borrow, for the first time in my life. It pains, worse than the worst sin you had ever committed. Debt came into my dictionary. Debt was bad, debt pains, debt is horrible. Stay away from debt. And so I fought for the next 4 years to repay my debts.

It was almost a natural progression that my gentle curious interest in money and piggy bank savings should lead me to work in a Financial Services firm. I did learn a lot on how to work; and learnt a bit on how they make money work for them. Margin became more than a pencil line on a white sheet of paper. I was surprised how much people risked, and for a few shares which they dont even get to see! Financial statements of companies made a lot more sense, although still meant little.

A switch to an insurance firm gave me an all too simple view of insurance. People paid for something which could never happen. People paid for a perceived risk, and some smart companies calling themselves insurance gave assurance that in case something bad happened, they would cover their families. And millions believed in this concept. And the fun part of it was that I did learn that insurance companies themselves insured!

Moving on to an investment bank, it felt weird. Is the world really this simple and foolish? People think banks are the safest places to put their money in, but banks invariably take the most risks! They give loans to people, they invest in companies, they trade like crazy. They borrow money from government/banks/people at a lower rate, lend to banks/corporates/people at a higher rate and pay people with the margin.

After a good five years in the financial services sector, I realised the entire financial system relies on one main thing. TRUST. If you lend money or borrow money, there should be trust between the parties. Worse still if you deposit the money in your favorite bank, which uses this money to buy shares, and sells shares that it does not own, and enters into repurchase agreements to fill the missing shares, securitises these shares with another bank to get more cash, and uses this cash to buy some government bonds, and gives this bonds to another bank to borrow more money and uses this money to give loans to a start up company hoping for a return on capital and to you as a house loan hoping you will pay the monthly interest, mitigates the risk of not getting back the money by getting another bank to act as a guarantee, gets whatever shares the company currently owns, sells those shares in the secondary market at a higher rate. And this example is just the tip of the iceberg. So, where is YOUR money? Its extremely complex in today's world, and nobody really knows where is your money. And my gut feel is that your simple deposit with your bank will lead that money to tie virtually every bank out there in some kind of transaction! So, if you want your money back, you are giving virtually every bank a run for their money :)

But, you say, the government is there to regulate. The bank does continuously calculate its balance sheet and tries to maintain a balance between its future cashflows, and keeps a percentage of the money it owes people as reserves, to please the regulators. But again, nothing is 100%. For you, the money you keep in the bank is safe. For the bank, the money it keeps is a loss! So, they went to a resort in Switzerland and came up with Basel 1 and Basel 2 to convince the government to let them trade as much money as possible, leaving their coffers as dry as possible.

Now, what if the key word goes missing. If TRUST is not there, between the bank and customer, or bank and bank, the whole financial system goes topsy turvy. Nobody wants to cheat, and no cheat can exist in the system for long. But then, what if you cant pay your house loan of Rs 10000 per month? Nothing happens. What if a million such people cannot repay. One housing loan company might go bust. What is one housing loan company goes bust? Nothing much maybe. What if 10 such companies go bust? The bank that fund these companies is screwed. As in the example above, that means almost every bank!

The survival of the fittest kicks in. Since risk is like a time bomb being passed across from one institution to another, the one that has the highest risk when the alarm bells ring bursts. The rest are tested for their survival. If someone does not have cash at that point of time, its time to say goodbye. ML and Lehmann found this out recently. The cash rich companies and banks see this as an opportunity to buy whatever they can. Consolidation results. The big and bounty survive. The small and fragile break. Its just the nature of the financial system.

Rumours test the keyword TRUST. A 4-pager "The boy who broke the bank" by Ruskin Bond is a highly recommended read for starters. Anything and everything in the fragile environment is a bank-breaker. A current example is of ICICI, second largest lender in India, whose shares dropped 14% in a day based on rumours that it does not have enough cash.

So, what can you do about it?
1. Have trust with people and institutions that you deal with financially.
2. Dont put all eggs in the same basket. Diversify your portfolios.
3. Bank is just another person. There is nothing which is 100% safe.
4. Dont go with the flow. Dont buy a house because every other colleague buys one.
5. Watch out for market signs. You should be very careful if you see every housewife buying and selling shares without knowing what it is!
6. Dont think you are too smart. A billion others out there are not idiots.
7. Start small, grow in chunks. You can dream big, but dont risk big.
8. Knowledge is power. Dont do anything without knowing what you are doing.
9. Patience is a virtue. For an individual, investment is good; trading is not.
10. It all boils down to fundamentals. Dont go by perceived value when the times are bad.

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My 2 cents on all things Finance - Part 1

Finance is THE hot topic now, with the banks going down the drain. Most people would have a rough idea of whats happening, but in layman's terms, its a sea of icebergs out there. In Lehmann's terms, it was just a poor Titanic!

Having worked in a Financial Services company, Insurance company and a Bank, I have a pretty good round up of the sector. Well, they say people who know more talk less, so before I get to know more, let me ramble on :P

I clearly remember the first bank account that I opened when I was entering into 2nd standard. My mom gave me Rs 10, the biggest amount I had seen till then in my own hands, and asked me to save. The next 11 yrs, I did just that; saved, saved and saved. My father was my first depositor, and my sister the first customer. Only that my customer returned neither principal nor interest. I learnt valuable lessons along the way. Seeing my piggy bank bulge and break, rise and ebb, I learnt what is love, sustenance, support, suspicion, sacrifice, despair, hope. Every month, I used to seggregate my 1p, 2p, 3p, 5p, 10p into seperate boxes and keep accounts. Over the years, I saw my beloved 1p and 2p disappear. Why shud those lovely chiselled aluminum coins be given back to the bank? New strange coins of Rs 2 and Rs 5 denomination came into being. My first taste of inflation. I did keep a few 1p, 2p and 3p though. It lost value, but did it?

Once in 6 months, my mom used to "buy" all my coins and give me a few equivalent notes, usually a bit more than the value of the coins. I didnt think much about the interest received, but I did cultivate interest. She used the coins for the daily bus journeys. I used to go to the bank and deposit the notes, way easier than depositing coins. I learnt how to deposit money. Occasionally withdrew money for emergencies, and got to know all the friendly neighbourhood bank employees. The bank used to have its own peculiar smell, just like a hotel.. It smelt of money and burning coils in the fans. I used to wonder why they worked only from 9-11am, until I realised my neighbour aunty working in the same bank came home only in the evening. As time passed by, I realised the bank shut itself inside, and people scribbling hard after people left. "Keeping accounts" I pondered, and mused how many 1p they had inside.

I opened my second bank account. This time my mom gave me Rs 100. WOW! And time went by and money went into the bank account. I ensured that hardly anything left the bank. I would be so delighted when they put the interest entry, as if I had won a lottery! When I ran from home near the closing time, and saw the shutters close agonisingly close, I used to pray to God to extend the banking hours. Its only when my passbook showed Rs 500 did my prayers get answered. And things started to get worse.

Did I open the pandorra box? The question would never go away. Growing up, I learnt it was not my prayers, but the world that was fast changing, but inside I always wish I hadnt wished 9-11 to change. The friendly neighbourhood aunties were now learning to type into the huge boxes obstructing my view of their bespectacled sincere work. I had grown enough to use a computer at school. I knew I could teach them to type faster. But the computers that I was so fond of at school transformed into frustration in their eyes. They were still scribbling in their ruled notebooks and into my passbook.

My balance grew into mammoth figures. I could hardly believe my eyes when I passed my 10th. I had a whopping Rs 1200. I screamed in silence. I wanted to tell all my friends, but I didnt. It was my WEALTH. Then my sister got engaged. My parents had to raise capital urgently for her marriage, and realised how tough it was to raise capital. Maybe people were as possessive about their wealth as I was with mine. I didnt think twice to open all my beloved boxes filled to the brim by then. 5p onwards flowed out.. totalling another Rs 250. They said they needed Rs 2.5 lacs. Thats when I realised how insignificant it all was. I wanted desperately to help my sis I had grown to love in hate. But I couldnt. I had saved all my life, and it came to nothing. I learnt the time value of money. In hindsight, I can see why its the first lesson in almost every financial book.


Quote of the week: Two investment banks were taken off the equation in a day.
Quote of the day: The Fed can take a dead dog as a collateral for lending money.

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