Understanding global finances and financial institutions

By Keith Evelyn

In order to enhance public understanding of national and global financial issues and institutions and the various ways in which they impact on society, Stabroek Business has asked Hand-in-Hand Group CEO Keith Evelyn to contribute a series of articles on these issues.
In this issue of the Stabroek Business, we publish the first in that series of articles.

The news today is all about the global financial crisis. Every day we read about banks and insurance companies collapsing all over the world. We see on TV, giant global companies that have been around for ages on the brink of collapse because they cannot get banking support. At home, we read and hear who says what about the state of the banks, insurance companies and the whole financial system. It can get really complicated especially for those who are not trained in financial matters. We hear terms like capital adequacy, liquidity, and insolvency. We hear about regulation and the duties of regulators.

It is very important that we try to understand what is going on. Why? First, what happens in the economy and the financial system of our country affects the well being of us all. Second, knowledge allows us to better assess the situation and make sound judgements on our own. It keeps us from panicking and making rash decisions that may harm us all.

It seems like everyone has an opinion. However, many of us do not really understand what these issues are all about at all and as a result draw the wrong conclusions. This article aims to discuss a few of the financial terms, principles and practices employed and talked about in financial circles today in a language that we can all understand. Hopefully, it would make understanding what is going on a little easier.

It’s all about risk
Finance is about money. One of the first things we need to understand about money is risk. We place our money in the bank because we do not want to risk putting it in the mattress or investing it in some business which we do not know much about; or maybe we’re just too lazy to get into. But we must agree that we want to make money or perhaps not to lose it. So we put our money in a bank.

The banks put all our (depositors’) money together and invests a little of it in each of their investments. This means that only a small fraction of our own money is at risk in each investment that the bank makes. Much less risky, isn’t it?

In insurance, we do not for example want to take the risk of having to finance a rebuild of our house should it burn down. So we spend a small amount of money compared to the cost of our house, to pay our insurance premium. This money is pooled together by the insurance company with the contributions of all the other people like us over many years and used to compensate whomsoever’s house burns down. Insurance Companies therefore spread the financial risk of the loss among all its policyholders and its shareholders.

This concept of spread of risk is very important; keep it in mind. Risk means the likelihood of losing. It is different from chance which means we can gain, like winning the lotto. So we risk losing our home to fire but we chance winning the lotto. Risk affects everything in our life. We tend to protect our life, limbs, loved ones and property, including money, so as to avoid risk, but we know we must accept that life on the whole is risky. It might even be fun to take some risk, but we don’t want to take risk that would certainly ruin our lives. We know for sure that we all will have misfortune at some time in our lives; we just don’t know when that will be and how bad it will be. When we make decisions regarding risk we are practising our own risk management.

Now what does this have to do with banking and insurance? Banks and insurance companies are typically companies which have been started up by their shareholders who have put up the original money called share capital and are the ultimate owners.
Let’s start with banking.

Financial Intermediation
Banks are considered financial intermediaries. Financial Intermediation is a big word to describe the process of channelling funds between those who wish to invest and those who wish to borrow. So if a bank gives a loan it is really lending out a little of each depositor’s and shareholder’s money to the borrower. The banker does not think, “Today I will lend out Mr. Jones’ deposit and tomorrow I will lend out Mr. Smith’s deposit.” Rather it says, “Today, I will lend out a little of the total of all my shareholders and depositors money combined.” The bank therefore spreads the risks it takes between its shareholders’ and its depositors’ money. Of recent, many people have been exclaiming, “This bank lent my money to so and so.” Yes, it did, but just a tiny bit of it. Messrs. Jones and Smith would be much more comfortable with this arrangement, don’t you think? When banks make deposits in other banks, it spreads the risk even further.

You would have figured that spreading risk means that many people share the risk but only a small amount of it each time; an amount that they can bear to lose without ruin.

Bad loans
If the borrower does not repay the loan, it is considered a bad loan. Banks make bad loans all the time, just mostly only a few of them.  If the loan is a bad one then first any loss first goes to the shareholders. If depositor’s value is threatened the regulators will insist that the bank employ strategies to restore shareholder equity until the situation is resolved. This means restoring capital adequacy which we will discuss later.

Mostly, all the banks’ investments as a whole do not make losses so large that they end up affecting the depositors’ money. Borrowers pay interest to banks and investments pay returns. When the bank makes money it pays you interest on your deposits and pays its expenses; then maybe some is paid to reward its shareholders and the rest is retained for future growth or to cushion future losses. Money retained by the bank in excess of its shareholder’s capital is called retained earnings.

Retained earnings can get negative if losses or bad loans diminish the value of the banks assets. In today’s global crisis many banks have negative retained earnings. Regulators expect that this would be offset by changes to the bank’s capital or other assets.

Diversification
To reduce the risk of any one bad investment or loan affecting the entire combined value of the shareholders and depositors money, a bank will make many different types of investments. Spreading the risk this way is called diversification. All the different investments of an investor put together is called an investment portfolio.

It is not hard to imagine that banks face different types of risks. How businesses deal with these risks is called risk management. Risk management is a highly developed field of study today. More on diversification later.

Liquidity
All the money, property and value a bank or any business holds are called assets. Moneys that it owes to others or may owe are called liabilities. An asset may be defined as liquid if it may be converted into cash quickly. It does not have to be cash, but something that may be easily sold for cash. A company can be considered highly liquid if it has lots of liquid assets. Liquidity is considered a very good thing because it means that companies can easily pay their debts. Cash is king as they say, but cash can be risky too because we keep cash in a bank. Even banks keep cash in a bank. If the bank fails then while we may have been trying to be wise we would have lost our cash.

Banks fail if customers rush in large numbers to withdraw their deposits because the bank may not be able to convert their investments for example, mortgage loans into cash quickly (liquid form) in time to meet their depositors’ demands. Liquidity is an important part of solvency and is related in accounting terms.

Solvency
Solvency is close to but often confused with liquidity. In normal accounting, liquidity measures are used to assess solvency. In banking, insurance and finance it takes on a different interpretation which often confuses non-insurers and non-banking professionals, even accountants.

One big difference between solvency and liquidity here is that in the basic accounting sense you can compare how much cash a bank or insurance company has to its current liabilities to see how liquid it is. This makes sense but it does not take into account the other sometimes hidden risk factors involved. Imagine two fire insurance companies having the same cash, the same assets and the exact same current liabilities at any point in time. You might think they are equally solvent. Now consider that one has insured ten times the properties that the other has in the same location. You can well figure that the one with the more properties insured had better be more liquid since it has the potential of having to pay larger amounts of cash should a big fire happen. In short its probable liabilities or risks have to be considered as well. You would say that one company is riskier than the other.

In case you are getting lost, don’t worry; it would help just to think of solvency as the ability of a company to meet its long-term financial commitments and to expand and grow. This is a general term, in insurance and risk management it is even more complicated and involves advanced mathematics such as calculating the probability of ruin of a company; it involves actuarial science.  Forget this fancy term for now, I’ll explain it later.

Return and Risk
Banks and other investors cannot escape the return risk trade off. If they risk money in investments they get interest or dividends; this is called return. If they do not risk the money they get nothing and cannot pay their expenses or pay depositor’s interest. With respect to interest rates, generally the higher the interest rate is the higher the risk that is associated with the interest bearing investment. Risk here is also associated with the time it takes to get the investment back. Generally the longer the money is to be invested or lent, the higher the risk therefore the higher the interest rate charged by the bank. Can you imagine why mortgage interest rates are so high?

Therefore if a bank or an investor goes for a high interest rate investment, he or she has decided to take more risk on that investment with the hope of a higher reward. In order to make sure that all the investments the bank or investor makes are not too risky, they invest only a portion of all the money they have set aside for investment.

Every person and bank has a different approach to risk. It’s human nature. Some like to take risks like dangerous sports, while some would just stay safe. The amount of risk you naturally would take is a measure of your risk-aversity. If you don’t like risks, you’re risk averse.

How much a percentage of the investment portfolio should any one investment be? There is much risk management theory about this. It is very complicated. Bank Regulators in order to keep it safe and simple, have laws, rules and guidelines as regards how much can be lent in loans or invested in other types of investments. However, as a general rule an investor should limit any single investment to that proportion of his overall that its shareholders can bear to lose.

Modern Portfolio Theory
Modern portfolio theory argues that an investor can put together a portfolio of investments in securities (shares of companies on a stock exchange) that has a return that is less risky than the return on any individual security in that portfolio. It supports diversification, but in a special way that is pretty complicated. Suffice to say, diversification seems to be one good way of reducing or spreading risk.

Systemic Risk
Systemic risk occurs when there is a sudden, unusually unexpected event that disrupts financial markets making them unable to effectively channel money between those who have it and those who have a viable need for it. In other words, something happens that stops financial intermediation. When this occurs, businesses and households do not have enough money and stop spending; businesses fail and a general economic decline or depression occurs.

Systemic risk generally relates to a country or a particular geographical area, or it used to; I’ll explain the ‘used to’ later. This has changed. But first, let us look at systemic risk and understand it better.

Suppose a country suffers a natural disaster that affects so many people in the country that practically no one can work or pay their bank loans and all business is disrupted. Everyone may want to go to the bank to get their savings but the banks cannot pay them because the money is mostly invested or lent out to people who cannot pay at this time. This is systemic risk at an extreme manifestation.

You can imagine that when this happens, even if a bank had many different investments in a country, it could not escape the systemic risk since all the investments would be affected at the same time. So when a bank diversifies its portfolio of investments in a single country or location it is really managing non-systemic risk.

You can figure out now that to manage systemic risk, the investor has to diversify across borders. For example, if something really went wrong with the whole of Guyana, say the entire seawall collapsed ruining all business or economic activity in the whole country, and completely eroding the value of the Guyana dollar, you would recognise that the bank that had some investments in another country would be in a better position than the one that is solely invested in Guyana.

You see now that overseas investments are not such a bad thing. Here’s a question you can now ask yourself. Which is safer, investing in Guyana or investing in a richer more developed country?

You can also now imagine that systemic risk can be political for example war, riots, or be natural disasters and so on.

Keith Evelyn BA (Hons.), BSc, MBA, FCII, ACIB, Chartered Insurer has been CEO of the Hand-in-Hand Group of Companies for the past fifteen years. He is also a Past President of the Insurance Association of Guyana. He is the chairman of the Small Business Council of Guyana, and holds directorships of the Berbice Bridge Company, E-Networks (Guyana’s leading triple-play internet service providers), and Prestige Motors (the official BMW dealer in Guyana).
He has degrees in banking insurance and finance from Sheffield Hallam University and Manchester University in the UK. He is also an Associate of the Chartered Institute of Bankers, UK; a Fellow of the Chartered Insurance Institute (UK) and a Chartered insurer (UK). He holds a Masters degree in Business Administration from the University of Liverpool (UK).

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