This article was triggered by some discussions I ran into on Twitter. My belief is that the economics literature on banking (with some exceptions) is a failure. From the perspective of advancing knowledge, the best course of action would be to ritually burn the literature, and start over from scratch.
no formal education in finance but I did find this article helpful in understanding the plumbing. thx for taking the time and I look forward to the rest.
There is a *lot* to absorb in this post, and I found it more difficult to absorb than most of your posts.
I agree with you that the "... core of the problem is that the economics fraternity started from the wrong place, and the incorrect description of banking was enshrined in Economics 101 textbooks." However, this post presumes that the reader is already at, say, Finance 201 or 301. Take this paragraph, for example:
"Banks are a levered financial entity, which means that they are a financial firm that has debt liabilities. The two main worries of levered financial entities are insolvency and illiquidity."
Now, I feel I could define insolvency risk and illiquidity risk and distinguish between them. But as someone who never worked in finance, I doubt I could precisely define a "levered financial entity" and I would be stumped if asked, "Do *non*-financial firms also have debt liabilities?"
Granted, your regular readers may, from practical business experience, have a very clear sense of what a "levered financial entity is." But if you wanted to reach a wider audience, you'd probably have to start at a more basic level.
Thanks for the heads up. I did define solvency/illiquidity, but there’s a fair amount of jargon I used. My concern here was that it’s looking like it is already taking 3 articles to cover ground that most econs would do in one. I hope to write a primer on banking, but this article would need a lot more expansion.
As to your points, I will try to clear them up. The “entity” sounds funny, but I used it because in the real world, firms like banks set up “special purpose entities” that will borrow to invest in fixed income. “Entities” is the generic term that covers all potential fixed income investors, while something like “financial firm” doesn’t.
Non-financial firms typically have debt, and may often have finance subsidiaries (e.g. GE Capital, finance arms of auto manufacturers, etc.). The difference between non-financials and financials is that the working assumption is that profitability is supposed to be driven by selling products. Financial firms make their profits between the spread on returns between their assets and debts (although banks increasingly want to earn fee income).
Thanks for your reply. The distinction between financial and non-financial firms is one that deserves a wider airing, especially given the dominant role within capitalist economies which financial firms have acquired in the past forty years.
Well, Hyman Minsky argued that all firms tend to have financial elements. The reason is that one of the most effective sales tactics is to bill the client later - i.e., get an accounts receivable. That means that cash flows are delayed, and the selling firm needs to finance itself in the mean time. It’s really only retail where customers pay up front (although they often use credit cards, which is an outsourced accounts receivable). The distinction is about the expected source of profits: are profits expected to come from the sales of “real” goods and services, or from financial transactions?
A lot of smaller pension funds would not use external leverage, but it would be more common among larger ones. The equity portion of the fund might not have leverage, but it can be done on the fixed income or real estate component. Even in that case, the large equity weighting means that aggregate leverage is much lower than a bank (10% equity or so). However, pension funds do have actuarial liabilities, and the need to make payments will create “liquidity events” that need to be managed. This is a different profile than a bank - banks need to accommodate swings on a daily basis, pension funds have periodic blips that need to be handled without impacting performance.
no formal education in finance but I did find this article helpful in understanding the plumbing. thx for taking the time and I look forward to the rest.
Thanks!
There is a *lot* to absorb in this post, and I found it more difficult to absorb than most of your posts.
I agree with you that the "... core of the problem is that the economics fraternity started from the wrong place, and the incorrect description of banking was enshrined in Economics 101 textbooks." However, this post presumes that the reader is already at, say, Finance 201 or 301. Take this paragraph, for example:
"Banks are a levered financial entity, which means that they are a financial firm that has debt liabilities. The two main worries of levered financial entities are insolvency and illiquidity."
Now, I feel I could define insolvency risk and illiquidity risk and distinguish between them. But as someone who never worked in finance, I doubt I could precisely define a "levered financial entity" and I would be stumped if asked, "Do *non*-financial firms also have debt liabilities?"
Granted, your regular readers may, from practical business experience, have a very clear sense of what a "levered financial entity is." But if you wanted to reach a wider audience, you'd probably have to start at a more basic level.
Thanks for the heads up. I did define solvency/illiquidity, but there’s a fair amount of jargon I used. My concern here was that it’s looking like it is already taking 3 articles to cover ground that most econs would do in one. I hope to write a primer on banking, but this article would need a lot more expansion.
As to your points, I will try to clear them up. The “entity” sounds funny, but I used it because in the real world, firms like banks set up “special purpose entities” that will borrow to invest in fixed income. “Entities” is the generic term that covers all potential fixed income investors, while something like “financial firm” doesn’t.
Non-financial firms typically have debt, and may often have finance subsidiaries (e.g. GE Capital, finance arms of auto manufacturers, etc.). The difference between non-financials and financials is that the working assumption is that profitability is supposed to be driven by selling products. Financial firms make their profits between the spread on returns between their assets and debts (although banks increasingly want to earn fee income).
Thanks for your reply. The distinction between financial and non-financial firms is one that deserves a wider airing, especially given the dominant role within capitalist economies which financial firms have acquired in the past forty years.
Well, Hyman Minsky argued that all firms tend to have financial elements. The reason is that one of the most effective sales tactics is to bill the client later - i.e., get an accounts receivable. That means that cash flows are delayed, and the selling firm needs to finance itself in the mean time. It’s really only retail where customers pay up front (although they often use credit cards, which is an outsourced accounts receivable). The distinction is about the expected source of profits: are profits expected to come from the sales of “real” goods and services, or from financial transactions?
Interesting article! What is the difference in leverage between a commercial bank and a pension fund?
A lot of smaller pension funds would not use external leverage, but it would be more common among larger ones. The equity portion of the fund might not have leverage, but it can be done on the fixed income or real estate component. Even in that case, the large equity weighting means that aggregate leverage is much lower than a bank (10% equity or so). However, pension funds do have actuarial liabilities, and the need to make payments will create “liquidity events” that need to be managed. This is a different profile than a bank - banks need to accommodate swings on a daily basis, pension funds have periodic blips that need to be handled without impacting performance.