loans and money

Competition

admin — Tue, 05 Oct 2010 16:46:48 +0000

In the past payday lending rates in many markets were regulated and set by regulators or by banks operating in a cartel. The global trend has been towards liberalization and allowing market forces to set lending rates. In most OECD countries, and in increasing numbers of emerging markets, free competition determines lending rates. Competition has resulted in lower spreads (the difference between what banks pay for deposits and earn on loans) in most traditional lending segments including corporate.
Other banks may have different cost structures and strategic objectives. One bank may decide to attempt to gain market share by undercutting on price or be prepared to make unsecured loans. Decisions have to be made as to whether to accept a lower market share or respond by matching or undercutting the rates and terms offered by the bank initiating the price war. Price wars can be dangerous and what starts as an attempt by one bank to gain market share can result in unchanged market shares and lower yields on these loans than before for all banks.
The following diagram provides a summary of the major macro-level factors that have an influence on loan pricing and bank positioning.

Economic and Interest Rate Outlook

admin — Tue, 28 Sep 2010 16:45:07 +0000

The macro-economic and interest rate outlook will affect the level of loan demand, the ability and willingness of banks to meet that demand and whether it is better to make fixed or floating rate loans. It will also have a significant impact on the level of delinquencies and resulting credit losses.
When an economy is experiencing strong growth this is likely to be accompanied by investment in new capacity and robust consumer demand. Demand for credit is likely to be strong and, in the absence of inflation, interest rates low. Economies are cyclical, however, and investment starts to turn into overinvestment. With signs of an overheating economy and concerns about inflation increasing the central bank is likely to start to increase the discount rate and take action to tighten money supply.
If this is accompanied by a demand side shock (whether domestic or export oriented) capacity utilization levels are likely to fall as will investment in new capacity. The strongest demand for loans is likely to come from companies that became overextended when the economy was expanding and to whom banks are reluctant to increase exposure. In many cases they will be trying to reduce it. Layoffs will start to have an impact on unemployment levels and hence consumer confidence and spending. The central bank is likely to change its bias for interest rates to neutral and then start to cut them in order to give the economy a boost. Supply and demand eventually come back into balance.
We have already noted how difficult economists find identifying turning points. The old wry comment is that “economists have forecast 10 of the last four recessions”. Extrapolation represents the triumph of hope over experience, however. Management has to have a view, whether that view is contrarian or consensus.
The general rules of thumb for a bank anticipating a sharp slowdown are as follows. Cut back exposure to the industries and sectors that have enjoyed the strongest growth. Cut back exposure to companies with stretched balance sheets (high net debt to equity ratios) or where debt servicing depends on continued growth and to those that require a high level of capacity utilization to break even. Increase exposure to defensive sectors such as fast moving consumer
goods and utilities. Reduce the term of new loans (if the ship is going to sink it is best to be one of the first to the lifeboats). Increase the level of collateral cover and quality. All of these actions are easiest to achieve with the benefit of hindsight, of course.

MACRO-LEVEL FACTORS AffECTING PRICING AND BANK POSITIONING

admin — Tue, 21 Sep 2010 16:44:57 +0000

Individual banks are affected by macro-level factors such as the economic outlook, competition and the availability to bank customers of substitutes to bank products. These factors will affect not just loan pricing but how the bank tries to position itself.

Time frame

admin — Mon, 29 Mar 2010 13:48:33 +0000

Should the time frame used be based on the term of individual loans? This may make sense when looking at the pricing of individual loans but makes production of consolidated numbers difficult. It may make sense also to look at default probabilities within a specified time frame independent of the term of individual loans. A problem here is that extrapolation over longer time intervals is problematic as changes in loss rates are not random and serial correlation is clearly present. A common time frame taken is one year and this may be appropriate in developed markets but in the context of emerging markets seems short and is definitely considerably shorter than the economic (as opposed to legal) term of many bank exposures.

Managed exchange systems.

admin — Tue, 24 Nov 2009 12:02:19 +0000

Managed exchange systems such as those with a currency peg or those that try to keep a currency within a defined band are potentially vulnerable to speculative attack. All foreign currency transactions have to go through the central bank, which manages its country’s foreign currency reserves. A speculative attack on a US$ base pegged system usually involves borrowing the local currency and selling it to buy US$. This is usually achieved by using the forward markets. Once the central bank runs out of US$ the pegged system is bound to collapse. Speculators do not act alone and do not have to have the financial resources to bet against the central bank, they are more akin to surfers riding a particularly strong wave.

Foreign Exchange

admin — Tue, 13 Oct 2009 11:57:58 +0000

The foreign exchange market is one of the largest financial markets in the world but it has no exchange. Trades are done by phone or by using computers and it is a 24-hour market. Major foreign exchange centers include London, New York, Tokyo and Singapore. The introduction of the euro seriously reduced the opportunities for foreign exchange traders to make profits as the number of opportunities for cross-currency trades fell.
Trading currencies is arguably one of the most basic trading activities of most large commercial banks. We have already examined ways in which countries can attempt to manage their exchange rates against other currencies. In fundamental terms, however, exchange rates are determined by balance of payment deficits (or surpluses), capital inflows (or outflows) and perceptions of likely future inflation and real interest rates.

The Real Effective Exchange Rate

admin — Wed, 01 Jul 2009 20:11:39 +0000

As noted in earlier posts, the REER is the trade-weighted exchange rate (NEER) adjusted for inﬂation. It is viewed as a good indicator of medium- to long-term currency valuation. If we look at the Russian and Turkish crises, we see beforehand that the Russian rouble and Turkish lira were around 50–60% overvalued on a REER basis. This provides extremely useful information in that it actually suggests that the rouble and the lira will have to experience signiﬁcant real exchange rate depreciations to restore equilibrium. That’s the good news. The bad news is that it does not tell you when that signiﬁcant real — and therefore nominal — depreciation will take place. In both cases, the rouble and the lira were overvalued for two to three years before the inevitable happened.
However, there are important clues as to when that REER appreciation may be about to end. Such REER appreciation usually causes signiﬁcant trade and current account balance deterioration. The fact that this does not have an immediate reaction in the exchange rate conﬁrms not only the existence of the J-curve but also the presence of signiﬁcant capital inﬂows. Such inﬂows can offset a widening trade deﬁcit for a period of time, but eventually are not able to. When they reverse, or rather when they just stop, the exchange rate comes under ever increasing pressure until such time as it collapses to restore equilibrium. This process can also work equally well with real depreciations. From the end of 1995 to mid-1998 the Japanese yen experienced an increasing REER depreciation. Capital outﬂows offset an increasingly improving current account balance until such time as they could no longer do so, whereupon the Japanese yen rallied signiﬁcantly, resulting in one of the most dramatic collapses in the dollar–yen exchange rate — or any exchange rate — in history. REER valuation and the external balance are both cause and effect. It takes a REER depreciation of a currency to narrow signiﬁcantly a large external imbalance. That said, an excessive REER appreciation can cause that imbalance in the ﬁrst place.

The J-Curve

admin — Wed, 01 Jul 2009 10:11:09 +0000

This is a particularly useful concept because it deals with that frustrating delay between the change in the exchange rate and the adjustment to the economy. Equally, it deals with both trade and capital ﬂows. Suppose international investors have been buying the equity and ﬁxed income securities of an emerging market economy such as Korea. For some reason, those investors “lose conﬁdence” in the Korean economic story and as a result the Korean won. What does that mean? In practice it means that international investors all try to sell at the same time. However, if investors all try and sell at the same time, chances are their orders will not be ﬁlled. The Korean won will fall like a stone, but on very little actual volume.
Classic economic theory suggests that a fall in the nominal exchange rate should lead to a reduction in the current account deﬁcit by making imports more expensive and exports cheaper. However, this assumes that the transmission mechanism from the exchange rate to export and import prices is immediate. We know however that this is not the case. Corporations tend to take a wait-and-see attitude in times of market distress, delaying major price changes until ﬁnancial and economic conditions become clearer. In economist jargon, as we saw in the monetary approach to exchange rates, prices are “sticky”. Thus, in our example the Korean won may fall without any immediate beneﬁt to the trade and current account balances. This is not completely a hypothetical example because this is exactly what we saw during the Asian currency crisis of 1997–98. Then, a crisis in Thailand focused investor concerns on much of the rest of Asia, triggering a general loss of conﬁdence in Asian assets and currencies. Asian currencies collapsed but on far smaller volumes than the extent of their declines might have suggested. The Korean won collapsed along with the Thai baht, Indonesian rupiah, Philippine peso and at least initially the Malaysian ringgit. Despite this, there was no immediate reduction of Asian trade and current account deﬁcits. Analysts of the Asian crisis will no doubt suggest that other factors were also at work, notably the high importer content within Asian exports. While this was undoubtedly the case, it does not detract from the fact that there was a clear and marked delay between the exchange rate move and the adjustment to the trade balance. For whatever reasons, Korean corporations delayed their price increases.
We can also see this at work from the angle of the exchange rate rather than the trade balance. As an exchange rate appreciates, it causes exports to become more expensive in the currency to which these exports are going and imports from that country to become cheaper. The initial reaction in the trade balance is not negative however. As the exchange rate appreciates, it causes export prices to rise and import prices to fall. This in turn causes the value of exports to rise vs. imports, thus the initial reaction in the J-curve is that the trade balance actually improves. While this is happening, however, the impact of higher export prices reduces demand for those exports, causing falling export volumes. In turn, falling export volumes eventually lead to a fall in the value of exports and thus to a deterioration in the trade balance. The delay between the fall in export volumes and export values and the subsequent impact on the exchange rate is reﬂected by the concept of the J-curve. That delay factor varies between exchange rates depending on speciﬁc export price sensitivity to changes in the exchange rate.

The Standard Accounting Identity for Economic Adjustment

admin — Tue, 30 Jun 2009 20:09:45 +0000

We looked at this brieﬂy in earlier posts, but to recap it is expressed as:
S − I = Y − E = X − M
where:
S = Savings
I = Investment
Y = Income
E = Expenditure
X = Exports
M = Imports
This can actually be expanded by breaking down “savings” into public and private savings such that:
( Sp + Sg ) − I = X − M
where:
Sp = Private savings
Sg = Government savings
Here, government “dis-saving” reﬂects having a budget deﬁcit. Thus, from this, we can see immediately that there is a possible link between a budget deﬁcit and a trade deﬁcit. If a country’s budget deﬁcit continues to rise, this is reﬂected on the left-hand side of the equation by an increasingly negative value for Sg . Unless this is offset by a rise in private savings or a fall in investment, this will eventually mean that the left-hand side of the equation turns negative. Of necessity in this circumstance, the right-hand side of the equation must also be negative, which in turn means that the country has a trade deﬁcit. Thus, a budget deﬁcit can lead to a trade or a current account deﬁcit. The link is not necessarily automatic. However, it should be assumed that widening budget deﬁcits, if sustained over time, lead to widening trade and current account deﬁcits. If we extend this, we see that at some stage widening current account deﬁcits will become unsustainable, requiring a real exchange rate depreciation. Thus, widening budget deﬁcits may eventually require real (and thus nominal) exchange rate depreciation.
Economists are not generally thought of as prone to high emotion. Yet, one has to say that the accounting identity is like a work of great art, hiding great intricacy and complexity behind the veneer of apparent simplicity. From this accounting identity, we can see how economies adjust to changes in fundamental conditions and therefore how exchange rates should adjust to those conditions. Again, this is probably best shown through an example.

CURRENCY ECONOMICS

admin — Tue, 30 Jun 2009 10:09:06 +0000

So far in this blog, the focus has been on trying to create new exchange rate models based on capital ﬂows to try to improve forecasting accuracy. As necessary as this is, it does not mean we abandon the traditional exchange rate models. Classical economic theory has provided the foundations for exchange rate analysis. The purpose of establishing a framework known as currency economics is to be able to combine the new with the exchange rate models and use both in a more targeted and focused way. Any major differences between this framework of currency economics and classical economics are more methodological than ideological. The traditional exchange rate models, focusing as they do on such factors as trade, productivity, prices, money supply and the current account balance, help provide the long-term exchange rate view. Capital ﬂow-based models are considerably more helpful and accurate in terms of predicting short-term exchange rate moves.
However, these two types of exchange rate model should not necessarily be viewed as polar opposites. The very purpose of establishing a speciﬁc framework known as currency economics is to create an integrated approach to exchange rate analysis, which is capable of answering the riddles of short-, medium- and long-term exchange rate moves. The two sides do have some common ground, and it should be no surprise that this common ground is to be found in the balance of payments model — given that it focuses both on trade and capital ﬂows. Within this, there are three speciﬁc analytical tools which should be of use to currency market practitioners in bridging the gap between short- and long-term exchange rate analysis:
The standard accounting identity for economic adjustment
The J-curve
The REER