Dangerous Lending and Over-Valued Assets : continued
Spotting Weakness in Banking Practice
Structural Flaws in Financial Markets
Banking and finance have flaws that arise from time to time:
- Dangerous Lending Practices: An untenable situation may exist when: short-term loans are continously rolled-over for long-term needs; too many loans are denominated in foreign currency; lending requirements are relaxed to boost profits; loans are supported by shaky collateral, like equities; or the supply of loan funds comes from abroad, subject to sudden curtailment.
- Over-valued Assets: When securities or assets that are important to the well-being of the financial system become over-valued — priced higher than justified by a commonsense appraisal of intrinsic worth — a sudden readjustment may occur, wiping out collateral and roiling financial markets.
- Overly-Complex, Non-transparent, Poorly Understood Systems: Whenever systems become too complex to understand or to adequately control, a danger exists.
- Overly-Rigid, Highly-Regulated Systems: Sometimes systems are entirely dependent upon the government maintaining and adjusting rules that are needed for continued operability.
An example would be Soviet Russia which became dependent on centralized micro-management of an entire economy.
Hedge funds, such as Long Term Capital Management show weaknesses of non-transparency and complexity.
In the financial derivatives market, major banks act as insurers of derivative contracts, without adequate accounting or transparency.
An example would be the Savings and Loan system in the United States that was predicated upon the government controlling interest rates among competitors. With the advent of money market funds, the government lost the ability to maintain these controls and the system failed.
Another example would be the tightly-controlled foreign exchange system that served Brazil well during the "economic miracle" of the 1960s and 1970s. When the government changed in 1980, giving rise to a corrupt democratic system, the strict rules and essential discipline could no longer be maintained and the economy collapsed, opening a decade of economic crisis.
A safe system is one in which every reasonable test of what might go wrong has an adequate response.
In Capital Flow Analysis, we don't focus on ordinary risks of individual businesses, such as a debtor not being able to pay a loan, unless this risk is so generalized that it could spread and effect prices in an entire market.
Keeping An Eye On Banks
In any event, we won't find structural soft spots in the financial system if we don't look for them.
The first place to look is in the banking system.
The first place to look for trouble is in the banking system.
Bank disclosure is generally poor and banks are a spawning ground for financial crises.
- If you don't work in a bank, the Internet is a place to seek weaknesses, reading notes to financial statements and researching operations you don't understand.
- Bank web sites, advertising and promoting products, are another source of information.
- Court cases about unusual banking practices are useful reading.
Once you're on to a suspicious practice, you may be able to find comments on the Internet by others who have noticed the same thing.
Common Triggers
In Lesson 20, we talked about the Five Horsemen of the Investment Apocalypse: War, Changing Leadership, New Economic Theory, Technological Change, and Demographics.
Such factors often trigger financial crises and should be considered when examining structural weaknesses you come across.
However, some market crashes may be set off by obscure causes, such as the Crash of 1987 which was related to program trading in derivatives.
Just as important as recognizing structural weaknesses and common triggers to financial crises, is awareness of the blinders that we all wear that prevent us from anticipating such events.
Before proceeding, check your progress:
Self-Test
Which of the following might weaken financial institutions?
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Structural characteristics that may lead to economic collapse include:
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Common triggers of financial crises include:
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