finance

Readers Question: In early American banking history, banks would issue banknotes to patrons that were supposed to be backed by gold and silver. My questions is, what did the patrons give the banks to get the bank notes, and why were many banks unable to make payment on demand when the patrons tried to exchange their notes?

Banknotes have evolved over time. Initially bank notes were issues in lieu of precious metals and were essentially I O U’s. A more technical term is that bank notes were ‘promissory’ – Rather than give gold to customers, banks gave a credit note saying they promised to exchange this credit note for an equivalent sum of gold or silver.

Over time, gold and silver were no longer used in the monetary system, thus bank notes became effective credit notes.

It was the  banks who were most keen to use promissory notes rather than deal in precious metals. Bank notes had the advantage that is was easier to transport, lower costs and, most importantly, enabled the banks to make better use of their assets.

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Readers Question: What do you think would happen if all depositors of a bank requested their deposits?

The Banking would probably collapse – unless it could secure unlimited funding from a Central Bank or other banks.

If a bank has deposits of £10billion. The bank will keep perhaps 1% in liquid assets (i.e. cash that can quickly be given to customers who demand it. Therefore, out of £10 billion, the bank will have cash reserves of say £100million. We say it has a liquidity ratio of 1%. Therefore, if customers asked for £100 million to be withdrawn the bank could do it. However, once customers require more cash, it faces a problem – The bank doesn’t have the deposits in a liquid form.

What banks do is they lend out deposits to other people. This is how they make a profit.  They pay you 2% a year to save money, then lend to someone else and charge 7%. They can do this because usually people don’t want to suddenly withdraw all their money and it is more profitable than simply keeping money behind the counter.

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Readers Question: How and why do firms use derivatives to hedge risk?

Financial derivatives are a mechanism for managing risk. They involve options to buy or sell at a certain price in the future. This means that a firm can guarantee being able to buy or sell a contract at a certain price.

Why Firms Use Financial Derivatives.

The main reason firms use financial derivatives is that  it is way to manage risky price movements. In a way derivatives are a type of insurance and enable them to ‘hedge’ against adverse price fluctuations. This is important in volatile commodity prices or when exchange rates may be volatile.

It is ironic that financial derivatives are often considered to be ‘risky speculation’ when there intended purpose is to insure against volatile markets. Of course, derivatives can be misused by speculators. Rather than insuring against positions, derivatives can be used to gamble on a way one increase in stock markets e.t.c. But, the initial purpose of derivatives is to reduce risk.

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Readers Question: To what extent can the subprime crisis affect the global financial market?

The subprime crisis refers to the rising number of defaults on US subprime mortgages. Basically, US mortgage companies sold a lot of inappropriate mortgages to people on low income and poor credit histories. Rising interest rates, and falling house prices are causing many of these mortgage owners to struggle with repayments. Therefore, many mortgage companies have lost significant amounts of money. Some of the leading US subprime mortgage firms have gone under and bankrupt. If it was just mortgage companies who went bankrupt, it wouldn’t be so much of a problem.

However, many of these mortgages were financed through securitization. Basically, the mortgage companies would lend the money to homeowners but would finance the mortgage loan by selling ‘mortgage bundles’ to other financial institutions. Basically, mortgage loans were financed by many different financial companies, not just the mortgage companies.

In the US, upto 70-80% of mortgage loans were financed by securitisation. In the UK, the rate is much lower about 21%. The only British bank to get into trouble was the Northern Rock. The Northern Rock, unsurprisingly had the highest rate of 61%.

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Yesterday, I mentioned future contracts could be used as a way to insure against risky commodity prices. This is one way that future contracts can be used. Unfortunately, future contracts and options can also be used to speculate on the stock market. Stock market options enable investors to take a position on the stock market rising or falling. If you expect the stock market to buy you can take out a contract to buy at a certain price. If the stock market rises you can then buy at the fixed price and immediately sell for the higher price. Options enable an investor to magnify his gains, but also can magnify his losses.

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Readers Question from:Trevor Downer. Glasgow. From what little I know the theory of Economics appears to have very little scientific basis. Two “experts” will give two different answers, add a third “expert” and yet another answer is provided.
Can someone explain to me why there is no easy answer to the problem of the Northern Rock Bank?I presume that the 26 billion pounds loaned by the government is the amount that the bank owes, including interest, to lenders to the bank. I presume that this money has been loaned by the bank to borrowers that have the assets that are equal to that amount and will return a greater amount over the agreed loan period.

This suggests to me that the simple answer would have been to close the bank down, for the government to pay that sum directly to the lenders and have the borrowers make re-payments directly to the government, thus, no losers and, over a long period, large gains for the government, ie, us the taxpayers.

Have I gone wrong somewhere? Where have I gone wrong? An explanation would be appreciated.

Firstly, you are absolutely right about Economists. Put 10 in a different room and you will get 11 different answers (or so the joke goes)

It is an interesting question.But, I think that if the bank is closed down i.e. made bankrupt, it is hard for the government to get its money back. Because if you declare bankruptcy there is no requirement to pay back your debtors. If the bank closed down it would be difficult for the government to get its money directly from the borrowers.

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