S6C8: Money & Banking

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a) Nature and role of money

Money is not a naturally-occurring element, animals species other than humans do not use it and early civilizations would barter goods, not sell them. Barter means exchanging X items of Product A against Y items of Product B and is very useful in obtaining food and other useful equipment not available in a given location. It also sowed the seeds of specialization as opposed to a system based on household self-sufficiency, whether in a hunter-gatherer lifestyle or in the context of sedentary land cultivation.

The above means money is a technology; it relies on artefacts such as shells, metal coins, paper money or nowadays digital bits. Let’s not blitz through this however because it is quite important and there is more than meets the eye. The first type of money system could be described as a hybrid with barter and uses physical commodities such as determined quantities or weight of crops, shells or precious metals such as silver, bronze or gold to facilitate exchanges. Not always the most practical, and as importantly, out of control of the feudal hands of the local ruler. This gave rise to what is termed “fiat currency”, which steps away from the intrinsic value embedded in a specific type of money and consists in the governing entity declaring a particular type of object as having value and being legal tender, because it can. Legal tender is not just about making a fiat currency acceptable, it goes further than that and makes it unlawful not to accept this currency. Otherwise people may still refuse to be paid with a currency deemed legal but not legal tender. As for a currency, it refers to a system of money in place in a particular region, at a particular time. An administrative region may allow several currencies to be used to settle transactions or it may restrict the legal modes of payment to a single fiat currency, generally the one it is in charge of issuing and managing.

The main forms of money throughout history have been coins and paper. For paper, it has always been about face value, but the worth of coins was historically tied to the trading value of their metal content. When a currency would lose some of its value, there would therefore come a point when the coins in circulation would be worth more when melted than the number that was written on them. To avoid such occurrences, gold coins were eventually replaced by silver coins, then bronze, then copper and now plastic. Computing heralded a final transmutation and it became possible to digitize most information, including the crediting and debiting of accounts so that money can nowadays transit and be stored in a digital format.

There is no doubting money has been central to the transformation of our society from the Stone Age to the Information Age we live in; leaving the negative aspects of mercantilism and of the mistaking of money as an end rather than a mean, there is no denying its usefulness. Its main functions are as follows:

It abstracts the value of a product and permits one to pay for goods without having to provide a good or service of equivalent value, as in barter. For the Seller, it is a way to realize value without having to purchase anything in exchange.
Unlike barter, it makes transactions possible at different times and different places. Selling Product A today may earn you 8 coins and you can spend 2 of those coins buying eggs on 4 different occasions.
The above is possible because money is a store of value and it is recognized as legitimate by decree or convention within specific boundaries, and possibly beyond.
Two coins or bank notes with the same face value are interchangeable, so money can be commingled. Accordingly, it can be accumulated, divided and spent in no specific sequence and, in theory, any coin or note is as good as any other – baring fake issuance, metal alloying and other unlawful tricks.
Money does not expire, or in the rare case where it is phased out, it can be exchanged for the new version before the deadline.

Note that the above says nothing about the fluctuation of the value of goods over time and specifically about inflation. This is a topic we will partially cover in the next chapter, in S6 Section 9.b on monetary policy.

Also, the accumulation and value storage aspects are indispensable features for the creation of capital, a concept we just discussed in S6 Section 7.e. Therefore, money should be considered indispensable in the development of farming, mining and manufacturing at scale and more generally any activity requiring a large upfront investment, whether it is to purchase equipment or because there is a significant cash flow mismatch between the time expenses are incurred until revenues start flowing in.

b) Banks as savings and financing conduits

Going by the previous paragraph, one would think it is necessary to save capital before deploying it into a new business. This is somehow problematic because it suggests one has to be really rich to start a large business, or alternatively one has to start very small and grow over time through the reinvestment of accumulated profits. This doesn’t work for some businesses with long research and development time or requiring a minimum scale to be viable – favourite examples would include designing and manufacturing passenger jets, creating and operating an airline or building an offshore oil drilling rig.

In those cases, an entrepreneur or an existing company may be able to borrow the necessary capital to purchase the required equipment and cover the lag between cash inflows and cash outflows together with the financing of the inventory of raw materials, semi-finished and finished but unsold products, what is termed the working capital. Typically the company or the founders would provide or source part of the capital and the remaining may be borrowed from a bank or another financial institution.

The question of the origin of bank capital then arises. The answer is that it is sourced from savings deposited with them by individuals or corporates as well as short-term liquidity borrowed from other financial institutions but this eventually rolls up to other deposits since no money appears ex-nihilo, besides that minted by order of the government regulating a particular currency and distributed by the relevant central bank. On this basis, banks and other financial institutions are like the circulatory system of the global economy, mediating between the savers and the borrowers.

Why would savers deposit their possibly hard-earned money with a bank? The answer is twofold: it is safer than hoarding it at home where one could rob it or access and spend it without authorisation, and it can earn interest. Interest is the remuneration given by a bank on a deposit and depends on the amount and duration of said deposit. This works for banks as well because they charge interests on the loans they make to borrowers, which also depend on the amount borrowed, the duration during which the loan is fully or partially outstanding, and the inherent risk of the loan – one way to illustrate this credit risk is that it would be deemed quite safe to finance the working capital or a profit-making company as compared to a company expanding into a new market or a venture building and selling a new product. So the bank will earn interests as lender, pay interests to depositors, and its profit would be the difference between those overall streams less its operating expenses, including the losses it makes on defaulted loans that have not and will not be repaid.

This explains why the faith in the banking sector stability is a tenet of its success; indeed if depositors start feeling unsure about a particular bank’s financial condition and withdraw the savings they had placed with it in large numbers then the bank cannot simply recall the loans it has made and may run out of cash to carry on normal operations unless it gets assistance from other banks or the central bank lending it money. The more people hear about other people taking out their money, the more likely they are to withdraw their deposit as well, and thus the higher the chance of insolvency become. Crucially, this collapse in confidence may spread to other banks as well, potentially creating a very damaging systematic failure for a country’s financial system and, in short order, for its broader economy. To avoid such a scenario, most governments require banks to maintain some capital adequacy ratio, i.e. not all funds lent out are sourced from depositors, and they themselves provide a certain amount of insurance on deposits so people don’t worry at the first rumour.

c) Debt Vs Equity

In the same way depositors and the government would like to see banks holding capital to de-risk the system, lenders want borrowers to put some of their own money at risk alongside them. One would think it is not much reassurance, if a business fails and only 30% of the total cash invested can be recovered from the sale of inventories, manufactured products and equipment, then there is still a very substantial loss of 70% lurking for the lender. This also means that even if 95% of the monies could be recovered, the lender would still lose 5%, therefore suggesting that lending is a very risky proposition. On this basis, investors would require the payment of interests commensurate with such risk, at rates too high to be sustainable in a conservative scenario.

The solution devised has been to slice the “capital stack” vertically, with the less risky part having a short repayment time frame and legal rights to recover their loans first in a default situation, and at the other end, the capital from the shareholders would only be entitled to the left overs, if any, upon recovery and does not have a scheduled repayment date so it can only be extracted from the company by way of dividends, if lenders who have a seniority position allow it. The permanent part of the capital is called the equity and the temporary one is called debt, and the lower the perceived risk of debt, the lower the interest rate on it.

The perception of risk is driven by the type of business being pursued, the previous experience and quality of the management, the macroeconomic and regulatory risks the company is potentially exposed to and the overall leverage of the financing facility being availed. For our purpose here, financial leverage will refer to the ratio between debt and equity, such as 70%-30% or 2.33x. That said, when there are different layers of debt, each investor will consider leverage from her personal perspective. So if the capital stack is 25% equity, 25% junior debt and 50% senior debt then the senior lenders will think 50:50 leverage and the junior debt investors will be looking at 75:25 with second recovery behind the first 50%. There are other metrics used to express leverage such as EBITDA (Earnings Before Interests Depreciation and Amortization) multiples but this goes beyond the scope of this chapter.

In a balance sheet, a term we came across in the previous chapter, the equity consists of the paid-up capital and the retained earnings; it should be equal to the sum of assets less the sum of all liabilities.

d) Payments

Money can be exchanged in one of two ways: directly, meaning without intermediation between the buyer and the seller, literally cash changing hands, or indirectly by debiting the buyer’s account and crediting that of the seller for the corresponding amount – this is called provisioning.

The exchange of cash relies on coins and bank notes, and here bank refers to the issuing central bank, not the deposit-taking banks. Until recently that is because there is now a hybrid version permitting the digital exchange of currencies. I use the word “hybrid” because, even though it is effectively peer-to-peer, there is still a need for a digital infrastructure such as blockchain. We will spend more time on this and cryptocurrencies, including the private kind, in section f).

As for the payment methods relying on the provisioning of accounts, the main three are cheques, bank transfers, and card payments. We will look at each of them, in this order. A cheque is a financial instrument whereby the writer of the cheque called the “drawer” provides instructions for the payment of a certain sum to the person named on the cheque as the payee, who is not necessarily the person to whom the cheque is given. The way this works behind the scenes is that the cheque will be deposited with the bank where the payee holds an account, the payee’s bank will then request for funds to be transferred from the drawer’s bank, after which this financial institution will check the validity of the cheque and, provided there is sufficient funds in the drawer’s account, the cheque will be cleared, the money transferred to the payee’s bank and the funds credit in her account there. This means there is a risk of the cheque being bounced, either because it is not valid, perhaps the signature doesn’t match that on record, or because there are insufficient funds to honour it. To prevent such a scenario, a banker’s draft may be requested. This is a variation on the standard cheque where the drawer’s bank will withhold the amount from the account before issuing the draft and the name of the payee will be printed on the draft to minimize the risk associated with it being lost or stolen. There are a few more variations on cheque instruments so if you are curious about this I include a link to the relevant Wikipedia entry at the end of this chapter.

The principle of bank transfers is easy to grasp: the drawer instructs his bank to send money to the account of the payee held with the same or another bank, possibly in a different country and in a different currency so that the transfer may entail conversion from one currency into another at a certain exchange rate. Until recently, this would require several days for the crediting of the account to take place so one of the two parties would have to take a risk: either the payment occurs first and the good is exchanged when the payee’s account has been credited, in which case the buyer takes the risk of the payee not honouring his side of the transaction and not delivering the good, or the good is delivered before or at the time of the payment and the payee takes the payment risk on the buyer.

The overall principle might be easy to grasp but the network infrastructure behind it is actually quite complex. Same thing for card payments that provide the benefit of obviating the delivery or payment risk inherent to bank transfers not happening in real time. There are two types of card payments: debit and credit. With a debit card, the payment will only be successful at the point of sale (PoS) if there is a sufficient amount on the account of the buyer. Prepaid cards are a variation of debit cards. On the other hand, with a credit card, the transaction can go through even if there is an insufficient of amount money on the account provided the shortfall doesn’t go above a pre-agreed credit card limit. Accordingly, the credit card issuing institution is taking a credit risk on the buyer to eventually be repaid and charges an interest rate to compensate for what is effectively an unsecured customer loan.

The ability to authorize a transaction within a few seconds and then, in short order, to process and settle the amount in favour of the seller, is made possible by elaborate and extensive payment processing networks with names that should be familiar such as Visa, MasterCard, American Express or Maestro for credit cards, or Plus and Cirrus for debit cards. I include a link to the Wikipedia entry for payment processor if you are interested in reading more about this.

e) Hedging and Exchanges

If you have ever purchased a house, you probably have taken out a loan lasting anywhere from 15 to 25 years. During this time, interest rates could move down, or up and in the latter case this could make it difficult for you to service your loan in a timely fashion, paying both the interests on the outstanding loan amount and repaying part of the loan itself. In order to mitigate against this risk, you may decide to take a fixed rate loan for the entire amount or part of it. This is called interest rate hedging because you are protecting your position against a rise in interest rate and the quid pro quo is that you will not benefit from a decrease in said interest rate. It is not only individuals who stand to benefit from hedging and many companies will resort to it to ensure the interest on their debt doesn’t potentially blow up – in fact some lenders may require such hedging in order to avail a loan.

This need for hedging by corporates also extends to other parts of their cash flows and cost structure such as currency exchange rates and commodity prices. For example, a steel manufacturer in China purchases iron ore and coking coal both denominated in US dollars but its operating cost base is in local currency, the renminbi (RMB, also knowns as the Chinese yuan, CNY) so it may consider locking in a certain exchange rate for a few months or years into the future before entering into medium or long-term sales contract, thus ensuring a certain range of profitability, barring any operational issue or sudden rise in its onshore cost structure. Similarly, it can also enter into financial contracts to hedge the purchase cost of the iron ore and the coking coal.

Such contracts are financial derivatives and they can be outright long or short position, or they can be options. A long position means you are buying a certain quantity at a fixed rate at a specified date or over a specified period, whereas a short position is the opposite so you are selling something that you do not have and will need to purchase later on to square your position, whether it is interest rate, a commodity price or a foreign exchange rate (FX rate). With options, you are not selling or buying the underlying but the right to buy or sell the underlying at a contracted price. For the purchaser of the option, this is a right, not an obligation, so you would exercise the option only if you are benefiting from it, if it is “in the money”.

This is not simply benefiting from or paying for a movement in the actual rate versus the contracted rate. If you have bought a call option for natural gas for a reference price of US$3.5/MMBtu and natural gas subsequently trades down to US$3.0 then you would not exercise your right because you would be better of buying in the market directly. If on the contrary it trades up to US$3.80 then you would stand to gain US$0.30 by exercising your option and at the same time selling this one MMBtu of natural gas. In reality, you would sell the option rather than exercise it, unless maturity is around the corner, because your option has an intrinsic value of US$0.30 plus some residual value due to the embedded optionality – that very same optionality your paid for in the form of the call option premium at the outset, just with less time to expiry left now, which is why this non-intrinsic optional value is called the time value.

A corporate may turn to its bank to enter into a derivative transaction, often with a view to hedge risks rather than take a position in the market. The market exposure will thus be transferred from the corporate to the bank who will try to offset this exposure through other corporate derivatives, or with other banks (this would be an “over-the-counter” transaction – OTC for short), or by purchasing options on an exchange. Exchanges are where securities, options, futures, FX and commodities are traded, they provide liquidity to the market and the ability to both hedge and take directional positions – meaning one stands to benefit from a move in a certain direction, which can be up or down, or both when combining several options to bet on enhanced volatility going forward. I include a link to the Wikipedia entry for futures if you want to learn more about this type of derivatives.

The best-known securities are bonds and stocks, even if they do not account for the largest volumes traded – this would be FX and interest rates. Bonds are the listed version of bank loans and stocks are the listed version of equity. A company becomes public when it first list securities in an initial public offering (IPO).

Just to place some names, major commodity exchanges include the LME (London Metal Exchange) and the CBOT (Chicago Board of Trade) where even soft commodities such as corn and soybean can be traded. For equities, many countries have their own and sometimes more than one. The largest in the word are the New York Stock Exchange and the NASDAQ (also based in New York) with the Shanghai Stock Exchange coming in third, trailing by quite a distance.

f) Trivia – Blockchain and private currencies

Exchanging physical cash requires the presence of both parties at the same place at the same moment and the only alternatives have for a long time required the mediation of financial institutions to debit and credit accounts, taking fees in the process, which is normal albeit sometimes these are not what one would call competitive and fair.

The third option, and this is only a few years old, is the peer-to-peer exchange of digital currencies via a decentralized infrastructure, with the technology of choice being blockchain. There are many complex aspects to it but the essence is that #1 new transactions can occur through a consensus algorithm preventing fraudulent transactions, or at least making them very unlikely, #2 the ledger is shared across various participants with redundancies, and #3 the history of each currency token is preserved within the code.

In theory, fiat sovereign currencies could be exchanged in this manner, but this is still a few years into the future and for the time being it is private currencies that have found a breeding ground in blockchain. A private currency is by definition not issued by a sovereign central bank and, at the time of writing, is not recognized as a legal tender in any country with one exception (El Salvador). This is significant, and there is a difference between being legal, which means being tolerated or acceptable by some merchants, and being legal tender which means any merchant must accept payment in such currency.

This has important consequences in terms of the value of a currency, and so does the scarcity of this currency. In this regard, even though most private issuers warrant they will cap the number of coins issued, the reality is that there is no cap on the number of private currencies that can exist so, in my personal opinion, such representation is misleading and, unlike fiat currency, private currencies have no intrinsic value and only serve to make their issuers rich, with the rest of the world losing in the process. Things are a little different for stablecoins, which seek to replicate major currencies in the digital space, but again these will probably lose their shine once governments start issuing fiat currencies on the blockchain or other digital infrastructure. I include a link to the Wikipedia entry for stablecoin in the next section if this is of further interest to the reader.