- Did not intelligently profile the risk involved in lending major portions of their credit in a speculative environment. Asset prices have seen a sharp and unrealistic rise and such volatility does not last long term (more on speculation later) in which case banks underestimated their risks. Or overestimated their gains.
- Did not responsibly structure their lending portfolios to diversify into stable markets, prone to less speculation. One of the first rules of investment - even in mutual funds or stocks - is to have a broad and diverse portfolio. Financial analysts examining this issue point out to the irresponsibility with which banks which are liable to go down have invested in unstable markets. If such banks had a foundation of stable portfolios from markets such as pharma, infrastructure and health services where speculation is less likely to influence your investment, there would have been a better chance of living to fight another day. It's a sad case of poor structuring where your most risky investments make up a major fraction of your credit.
b. Know where your debtor is coming from
A bank that fails to examine the credit-worthiness of a prospective debtor fails to do its job. One does not need to elaborate on this, except for the fact that a highly 'positive' market tends to build on euphoria and kill rationale in decision making.
c. Know where your money goes
A lot of people talk about complex securities and inter-linked securities. People complain that banks that had mortgage backed securities ended up using such securities to cover their own from their own creditors. What I do know is that when a bank which first does not analyze its risk on an investment properly, then passes on the risk on such an investment to gullible creditors has only compounded the sin. Creditors who did not realistically analyze the risk behind such securities were partially to blame. The solution is to hold banks accountable for the securities they market and tie these to a specific asset - which when assessed independently - can be shown to be overpriced or volatile.
Judging from some of these decisions, I believe the current crisis is a result of poor financing decisions, the principles of which have been lost in the illusion of short-term gains. The answer to this crisis does not lie in drastic measures but in a return to the forgotten first principles in banking
And now to touch upon speculation :
Speculation - Is it really that bad ?
It has been pointed out that the root cause of all this mess is a highly speculative environment. Hence instead of just regulating banking institutions, regulate speculation as well. I tend to disagree with this line of thought for a couple of reasons:
Suppose a product is scarce in the market and yet reasonably in demand. The price for such a product is high but expected to go higher due to the scarcity value and demand. A speculator, seeing the future potential of profiting from the sale of this product, comes to town and buys large quantities of this product at existing prices. This speculative buying pushes the product price even higher to a point where some consumers forego the purchase of the product. In other words, demand/consumption reduces by way of speculative buying. Secondly, when prices are higher than speculators like, they sell. This reduces prices and encourages consumption.
The bottom line here is : The short-term volatility in prices ends up regulating prices faster.
Speculators also tend to invigorate markets which do not have enough liquidity. A product that is low in demand will have a big disparity between the price a new entrant to the market is willing to pay and the asking price. A speculator, in conjunction with competing speculators, tends to reduce this disparity and create a more efficient market.
Regulating speculation for fixed periods of time (due to the above reasons) can also have the undesirable effect of prices changing with a huge lag with respect to demand and supply. The time lag will create more inefficient markets.
I believe one needs to think of addressing a major malady in the system - the folly of predatory lending and abuse of banking principles - which will come with more financial regulation. Such efforts will ensure greater robustness against volatility in secured lending than shooting small birds.
3 comments:
Banks that are suffering or likely to suffer are most likely the ones who did not intelligently profile the risk involved in lending major portions of their credit in a speculative environment
Until the speculative environment is busted, most people do not realise that it is a speculative environment. Rather, tens of retrospectively-fitting theories are invented to explain why the markets are rising at such a rapid pace, and how there is a "paradigm shift" now, because of which they will keep rising forever. Thus, lenders make the mistake of lending for investing in speculative environment, because they don't know it is one. It is very difficult (sometimes humanly impossible) to say for sure that the environment is speculative, simply because there are so many factors involved. In such a case, there is a high probability of miscalculating the risk involved.
A highly 'positive' market tends to build on euphoria and kill rationale in decision making.
Again, as there are so many factors that affect a particular market, it is extremely difficult to judge whether the rise is based on real economic factors or simply speculative activity, to judge whether it is euphoric or whether it is rational. A case in point? The current situation that the world's commodity markets are finding themselves in. Though I am of the opinion that a large part of the boom in today's commodity markets is speculative, I can't be sure. It was similar experience during the US real estate boom.
The answer to this crisis does not lie in drastic measures but in a return to the forgotten first principles in banking
This could well have been the solution if banks were the only source of credit. But, now there are many (and equally powerful) sources of credit. So even if banks return to (or are forced to return to) sane banking principles, the turmoil in world markets and the speculative boom and bust cycles will not get stamped out. And the situation of credit crisis will continue to come back time and again.
This speculative buying pushes the product price even higher to a point where some consumers forego the purchase of the product.
This is true for a market that the current economic theory describes: "when the price goes up, the demand goes down". The trouble with a speculative market is that it does not follow the current economic theory. Because in a speculative market: "when the price goes up, the demand also goes up". Because more people are tempted to buy something whose price is going up, so that they can sell it later. In other words, demand/ consumption increases by the way of speculative buying.
When prices are higher than speculators like, they sell.
There is no price high enough for speculators to not like. That's because speculators are not consuming that item, they simply want to sell it at a higher price. So, if the price of that item is going up, they'll still buy it, no matter how high is the price. A speculative boom ends only due to an external factor. For example, a speculative stock market boom would end when the economy looks like slowing down. Never when the speculators decide to call it a day.
Speculators also tend to invigorate markets which do not have enough liquidity.
Agreed. But what purpose does it serve? And at what cost? What are the positive effects of this?
A product that is low in demand will have a big disparity between the price a new entrant to the market is willing to pay and the asking price. A speculator, in conjunction with competing speculators, tends to reduce this disparity and create a more efficient market.
Yes, if you remove speculation from markets, the demand for a product will be much lesser than today. The volume of shares traded and the turnover will be much lesser too. But, so will be the supply. In any case, both the forces will still balance each other and price discovery will be efficient. Also, if speculation creates a more efficient market, then how can one explain, to give an extreme example (although true), increases of up to 100,000% and decreases of 99.99% in share values of companies during the tech bubble of 1999-2000?
Regulating speculation for fixed periods of time (due to the above reasons) can also have the undesirable effect of prices changing with a huge lag with respect to demand and supply.
This would be true if the entire stock of a particular asset was allowed to be traded only periodically. For example, fixing a single date for trading all the shares on the stock exchange and then suspending trading for the next 1 year, will show the above phenomenon of time lag in the change of prices. But that's not the case. Assets are allowed to be traded all the year round, so the price changes happen everyday. The only difference in this case is that when there's a regulation that one cannot sell the shares he just bought, until one year has passed, one will consider the performance of the company over the next 12 months (which will decide the price that he will get for his shares then) rather than consider whether the price of the shares will go up tomorrow (or even after an hour).
Until the speculative environment is busted, most people do not realise that it is a speculative environment.
One cannot get a perfect fit about *all* the factors affecting a rise. But usually analysts are able to predict and tap the pulse of a financial cycle, much like an economic cycle. Hyman Minsky proposes cycles of financial fragility much like economic cycles. Post-recession, financial firms tend to play safe and hedge their risks for a while. As the economy grows, firms lend with an element of speculation, even though their debts are not fully covered by their profits. They believe profits will rise sufficiently to repay these debts. As the economy grows, lenders begin to believe that they can lend with more risk and lend firms without full guarantee of success.
My point in all this theorizing is that – financial/banking analysts don’t need complicated mathematical models to gauge the pulse of a rising/falling economy and accordingly plan their lending structure. A speculative economy often plays itself out by assessing past growth and figuring out where it stands vis a vis growth cycles. It’s not fool proof I admit in the sense that one cannot predict when the bubble will burst, but once you know that a bubble exists, lending in that sector should be conservative.
Again, as there are so many factors that affect a particular market, it is extremely difficult to judge whether the rise is based on real economic factors or simply speculative activity, to judge whether it is euphoric or whether it is rational.
The point is if every investor (not speculator) ends up diversifying his portfolio between markets that have historically resisted speculation and markets that are prone to sharp volatility, both banks and individuals would not have lost as much money. Add to this the fact that banks did not provide credit to worthy individuals. Speculation is only part of the issue and if I am right, not THE issue but a mere catalyst which took advantage of poor lending methods.
So even if banks return to (or are forced to return to) sane banking principles, the turmoil in world markets and the speculative boom and bust cycles will not get stamped out. And the situation of credit crisis will continue to come back time and again.
You seem to be conflating the issue of poor lending and speculation in 1 single issue. That is not the case. Any lending institution (banks or others) should assess risk associated with lending and diversify and structure lending appropriately. Even if this means at the cost of growth. A conservative lending approach ensures survival at any rate. Speculation or no speculation. Economic cycles – booms and busts – are unavoidable in a capitalist structure. The volatility you want to stamp out by regulation is occurring at the risk of the speculator – such risk does not need to be necessarily absorbed by the lending institution.
Because more people are tempted to buy something whose price is going up, so that they can sell it later. In other words, demand/ consumption increases by the way of speculative buying.
Yes, but they do so at high risk to themselves and by ensuring higher liquidity in the system. Investors know when to hold on and speculators buy/sell impulsively. My question is should we assume intellect over other people’s decisions –good or bad ? Free market economics is essentially allowing this very diversity to play itself out. I don’t agree with telling people “Look, I know what’s better for you. Hold your stocks for a year, or you’ll lose your life’s savings”.
There is no price high enough for speculators to not like.
Slightly strange statement this. I think there are deterrent limits for speculators.
A speculative boom ends only due to an external factor. For example, a speculative stock market boom would end when the economy looks like slowing down. Never when the speculators decide to call it a day.
Agreed that the price rise and falls are artificially influenced. However, the volatility cannot be sustained in the long term – especially the period of a long term mortgage backed loans such as the ones that caused this crisis. In which case, banks/lending institutions should not have distributed the risks associated with such markets to other creditors.
The volume of shares traded and the turnover will be much lesser too. But, so will be the supply. In any case, both the forces will still balance each other and price discovery will be efficient.
It is not the price discovery that I’m talking about. Market efficiency also involves more people profiting from the market. In other words, a rupee that was earlier not being earned from a previously low market is now being earned. Higher GDP, etc etc.
increases of up to 100,000% and decreases of 99.99% in share values of companies during the tech bubble of 1999-2000?
Why is volatility being confused with inefficiency? Higher volatility implies that the market is better placed to correct wrong pricing and faster. Adding to the fact that people who are willing to make money at higher risk are able to do so.
The only difference in this case is that when there's a regulation that one cannot sell the shares he just bought, until one year has passed, one will consider the performance of the company over the next 12 months (which will decide the price that he will get for his shares then) rather than consider whether the price of the shares will go up tomorrow (or even after an hour).
Fair enough, but why would you want to deprive him of a rupee that could be worth more if earned tomorrow? Who’s interests are you trying to preserve here – his because you know better or someone else’s ? One year down the line the rupee may not be as valuable, inflation may have doubled or the investor would have suffered a heart attack.
Aaarghhh!!! Another long discussion! Let's add it to The List.
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