Banker Blog#6 Why change the currency?

Have you seen the new UK pound coins yet?

New, shiny, a bit more elaborate than the dull old coins, I like them.

It prompted some discussion mostly, to the effect of people complaining changing the coins is a waste of time and money. I would have to disagree, there are three valid reasons why it is necessary to change the notes, coins and more in circulation.

Firstly, the prevention of counterfeiting

I view most of human history as an arms race between the law and criminals. We come up with cheques, criminals learn to forge signatures. We invent currency, criminals counterfeit. We come up with banking online, criminals start hacking. The longer a currency is in circulation, the more fake copies will be made and also the better the copies will be. Counterfeiting is even used in warfare to destabilise an enemy nation’s economy, that is how dangerous it is. We need to play a bit of musical chairs and just when the criminals have perfect counterfeits, we change it.

Secondly, cultural reasons to change currency

A currency says a lot about a nation, who it decides to put on the notes and who it thinks are worthy of praise and attention. As time passes, new and increasingly diverse figures are deemed worthy of the honour of being on currency.

Generally speaking, you want to pick someone who is dead (so they can’t do anything controversial and force you to recall the coins/notes). You also want to stay away from politics because generally every politician may be loved by half the country and despised by the other half. Go for science or art. It can also be a chance to draw attention to lesser known figures. Darwin, Maxwell etc. these are the faces you tend to see.

Thirdly, economic

The composition of coins can change as the economy of a country changes. Back in ye olde days solid gold coins were the norm (these are worth a fortune if you ever dig them out the ground). Then we started mixing them with other metals and the actual objective value of a coin was based purely on the metal it is made of became worth less and less.

If a country finds a cheaper way to make a coin, it will do, since they are mostly symbolic anyway. Look at Canada where they eliminated the penny, it cost more to make than it was worth.

What to take from this blog?

Physical currency changes constantly for security, cultural and economic reasons, it isn’t done on a whim for no reason. There is also a distinct possibility that in a very near future, physical currency will die out completely but that is a blog for another day.

Banker Blog #5 Hostile takeover mahahaha

Even the name sounds sinister, a hostile takeover. What better way to kick off the holiday weekend than one of the most controversial topics in business? There is plenty of sunshine and happiness to go around, lets delve into this for ten minutes.

What is a hostile takeover though? In films it seems to amount to something illegal, some heavies coming round to see you in the night. As always when it comes to the business world, the films get it wrong.

You remember in the last blog we explained how management run a company for the shareholders who own it, vote on major decisions and want increased profits? Keep that in mind when we explore this hypothetical situation.

Lets play some war games where you consider how you would act.

***

You want to buy a rival company that has been standing in your way for too long. This town isn’t big enough for the two of you and it is time to take action.

You approach management and the CEO, explaining you want to buy the company. They are not keen to sell though and tell the shareholders it would be a mistake. Listening to their own management, the shareholders decide not to sell, the company’s best years are still ahead.

Damn! You don’t need this thorn in your side.

If the nice way won’t work, time for a hostile takeover.

You approach individual shareholders, offering them ten times what the stock is worth. They see dollar signs and sell. You do it discreetly, maybe even using intermediaries, by the time management see what is happening, you own 51% of the stock, that’s 51% of the votes.

What happens next is up to you. You can have the company vote to dissolve itself, ending the threat. You can merge it with your business. You can allow it to exist as an independent brand but one you control.

Checkmate, you win.

Now lets flip it!

You are running a company, minding your own business and some insufferable twerp tries to buy it! Grrr. The shareholders are worried and want to know how to defend against these machinations.

  • Urge the stockholders not to sell. This is naive though, everyone has their price, you can’t just wait and hope, so a hardnosed leader like you will take action.
  • Golden parachute- you set the condition that if the company is ever purchased, all the leading executives (like you) by law must get huge pay outs. This makes the idea of taking over your company unappealing.
  • Pacman defence- I love the name of this one. You know when the ghosts are chasing pacman and you get the power ball, they turn blue and then you gobble them up? I think of when Mr Burns discovered that in the Simpsons when introduced to the game, “now the hunter has become the hunted!” This company trying to buy you? You turn around and try and takeover it! Brilliant, you carry out a hostile takeover on the company trying to buy you, approaching their shareholders. An example of the best defence is a good offence.
  • Crown Jewel- this defence means you add a clause of the company is taken over, you need to sell all the valuable assets of the company. So if you are a taxi company, a crown jewel defence would involve the clause in your company constitution that if a rival buys you, the fleet of cars will be automatically sold.

 

There are more nuanced takeover methods, more ways to prevent it but as always, the point of this blog is to give you a fundamental understanding.

Hope that was useful, go enjoy the sun and holiday.

Banker Blog#4 Share & Share Alike

You know by now my deep-rooted suspicion when a story or article doesn’t feel a need to properly explain what is happening.

“Shareholders furious”

“Management and shareholders clash”

“Shareholders approve banker bonuses”

Little and indeed no time is ever spent giving a quick one liner on what shares mean.

Before we move onto other topics like hostile takeovers, leveraged buy outs and all that, we need to make sure that we know what shares are. If we can nail that foundation, everything else will flow naturally.

What are shares?

If you own a share, you own a bit of a company. A share is a unit of company, it is how you measure how much of the company you own. A company issues 100 shares, you buy 1, you own 1% of that company and have become a shareholder. Even if is only 1%, you are still a shareholder with rights and responsibilities. (Stock and shares are words that can be used fairly interchangeably).

Why buy shares?

If the company makes a profit, you get that. Usually it is in proportion to your shares. In the above example, you own 1% of the company shares, it makes £100 profit, you get £1. The person with 25% of the shares gets £25 etc.

What does a shareholder do?

Shareholders often vote on important company decisions, will appoint directors and a CEO, approve their salaries, show up for the annual general meeting.

If you own a share in The ABC Company, and they are thinking about moving their HQ from London to Berlin, you can bet there would be a shareholder vote on it.

Management versus shareholders

Shareholders own the company, management run the company, and they can clash from time to time.

I always think the best way to understand how these disputes can arise is to put yourself in the shoes of the other side.

You as a shareholder

If you are a shareholder, you are interested in the company making as much money as possible. The company makes a ton of money, your dividend is bigger, happy days.

If your management are harping on about wanting higher salaries, or launching a costly new product range, you are going to be sceptical. They will really need to persuade you. You might be worried your management are showboating, wanting to do all these crazy new schemes to make a name for themselves whereas what the company really needs is to stay the course.

You are interested in your bottom line, you own shares and as long as they keep making you money, you are happy. When they start losing money, no matter what excuse is given (we are launching a new product, we are restructuring, we had a tough year) you get annoyed and consider even selling your shares.

You as a director

You are the leader of a company, martialling the workforce, implementing new strategies. What you want is to have an efficient, strong company because your name is associated with it. You can sometimes chafe with the shareholders. For example, you have seen that there is a huge market for a new product. You want to launch it, creating a team to manage it and make a big splash in the market. Now only will this be good for the company long term, you can implement your plans and see if they work.

It will mean the shareholders won’t get dividends for a year or two- and guess what, they are up in arms about that grrr. You fight with them, they threaten that at the next AGM they won’t be picking you for the director.

Worse yet, given that you wanted a pay rise as well, there is even more hostility!

***

There have been some pretty spectacular fallings out between shareholders and management, especially in the banking sector.

  • During the financial crisis, the government purchased stock and holds a controlling interest in some banks. So the government was a massive shareholder in these companies (as much as 85% in some banks).
  • At the first meeting with the shareholders, the government refused to give them bonuses and wanted their salaries cut.
  • The bankers, who are the management, are furious and say they will resign- this will cause the bank to crash and be worthless.
  • Stand off between the management and shareholders.

 

Activist shareholders

Most shareholders sit back and as long as they are paid their dividends, aren’t overly interested. A rough generalisation but often true.

There are two kinds though of activist shareholder

  • Business minded activist- really go to town on the management and hold them accountable. Even if you had a good year, these folks will be on your case. They watch and count every penny, so if a director had a coffee on the company dime, they will point it out and want an explanation. They want high profits and tight costs.
  • Social minded activist- they are interested in the social parts of a company. So they will often challenge directors on diversity, negative press stories, environmental impact, stance on political issues. Being a shareholder gives them the power to influence the company.

This is a very general introduction to shares but if you read this and understood it, you have a solid foundation for everything else to come.

 

Banker Blog#3 Liquidity

“You’re thinking of this place all wrong. As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house…right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others. Why, you’re lending them the money to build, and then, they’re going to pay it back to you as best they can.”

George Bailey, It’s a Wonderful Life

 

It’s Sunday, I hope you have your broadsheet financial times folded on the breakfast table, glossy economist sitting nearby and mug of coffee/pint of orange juice ready.

People seem to be enjoying these banker blogs and thanks for the positive feedback. As I said the point is to take what can seem like complicated banking terms and break it into an easily readable paragraph or two. I have a passion for writing but also love the day job in banking, combing the two feels natural.

Having read the first two blogs, you will already have a better grasp of banking than the vast majority of people, now to look at another area.

Liquidity is a common topic when looking at banks but little or no time is spent explaining what it is (thus further fuels my fear that a lot of journalists don’t know what these terms mean and simply echo what they have heard).

What does liquidity mean?

Liquidity is how quickly something can be converted to cash. The money in your wallet has high liquidity, it is already money, you can use it right away. Your clothes, books, games have medium liquidity, you could probably sell them on amazon and get money fairly quickly but it won’t be instant. Your house has low liquidity, it could years to turn it into cash, you would have to contact housing agents, put it up on the market, sell it, conduct the missives etc.

If I need money and have liquidity, it is not an issue. The pipes burst in my flat, plumber charges £100, I have that in my wallet, no problem. If I don’t have that cash, I can sell a few things of medium liquidity and get the cash in decent enough time to pay the plumber. I am in trouble if all my money is in the house and plumber wants paid by the end of the week- no way I can sell the house by then. Low liquidity can be a problem.

How does this impact banking?

People use banks as a safe place to put their money. An incorrect assumption is that money is sitting in a vault somewhere.

Let’s say you put £1000 in the bank. The bank will use that money for various activities. The bank has calculated that you won’t want to withdraw all that money at the same time so it only keeps say £500 in reserve. It does this for everyone, people rolling up to withdraw everything is so rare that they feel comfortable only having half that money in the vault. To sweeten the deal for depositors, a bank pays interest from the money it makes on loans (that’s where your interest comes from, the bank loaning out money).

The bank uses the money to provide loans, mortgages and credit to other people, loaning out the money. These generally have every low liquidity as it can take years for people to pay them off, giving the bank the money back.

So why not have total liquidity?

Some of you might be worried about the idea that banks couldn’t give back all their customers all their money if they had to. Let’s say a bank does just sit with all the money, 100% liquidity, this would actually cause significant problems for society.

  • How can banks stay in business?

So the bank takes £1000 from you and sits with £1000. Well the bank isn’t making any money off that. The bank will even be losing money if they still pay interest. How on earth can they stay in business? Simple answer is they can’t really and so they buckle and close. As horrible as the antics of some bankers were during the 2008 crash, if you want to see extreme corruption, look at countries that only have one, massive, state owned bank.

Some banks can charge fees for holding your money but even these banks need to invest and lend. For a bank to exist purely on account fees, with no lending, these fees would have to be eye wateringly high, unacceptable to most consumers.

  • Goodbye fair loans for the rest of us?

Some brave banks decide to try and stay in business despite the demands for total liquidity. How could they do that in these extreme circumstances? The bank directors will use their own funds, not the depositors, to be used for loans. These handful of loans will either only be given to people who are sure bets (so a massive segment of the population lose access to easy finance like credit cards, loans, overdrafts etc) or alternatively with such extremely high fees and interest, it overrides the risk. Neither is very appealing.

A Bank Run

A Bank Run is when most the banks’ customers walk up and demand their money. As previously explained, the bank doesn’t have this, so they can’t. Like wildfire panic spreads, the banks’ low liquidity becomes a fatal flaw, more people join the queues to withdraw their life savings- which conversely makes the situation even worse. Think Northern Rock here in the UK.

Banks start to demand loans to be paid right away, they start foreclosing on houses where people were in difficulty, they do everything they can to get their hands on cash but it is a death spiral.

A run on a bank is one of the most awful events that can happen in banking, everyone suffers.

What to take away from this blog

Banks take money but it isn’t sitting gathering dust, they do things with it which is necessary to ensure the smooth operation of finance in general, from mortgages to loans to credit cards.

Banker Blog #2 Bank of England and Base Rate

As you can see from the picture I snapped, I was recently in London on business and couldn’t resist going to see the Bank of England. Since 2008, it has become an organisation that previously shunned the limelight to being a hot topic, the governor Mark Carney constantly being interviewed and defending bank decisions.

It is common enough to see headlines in the news such as “Bank of England to cut base rate”, “Bank of England threatens to cut base rate” and “2017 could see unexpected rise in base rate”. Often they cut out the base part and discuss rates which is a fairly inaccurate term but they mean the base rate.

These same stories never bother to explain what the base rate means, how it is decided, why someone would raise or lower it. It is left so vague I sometimes wonder if the journalists writing the articles even know. Like a lot of these banking terms, it is very simple.

What is the Bank of England?

The central bank here in the United Kingdom, comparable to the Federal Reserve in the United States, Banque de France in France and Deutsche Bundesbank in Germany.

What does it do?

Like all central banks, it is concerned with the stability of the financial system, currency and managing booms and busts.

What is the base rate?

  • Banks use the base rate in their calculations.
  • Banks will often charge a loan as “base rate + 4%”
  • Banks will have the deposit on their accounts for interest as “base rate + 2%”
  • So lets say the base rate is 1, and your loan is Base rate +4%. Then 1+4%, so 5%.
  • Note- It is possible to have a fixed rate on your loan, where there is no base rate element but most are base rate linked.

Why lower the base rate?

Keeping that in mind, if the central bank wants to encourage growth, it slashes the base rate. That way if you want to start a company, buy a house, buy a car, the loans you take it to do it are very cheap. Slashing the base rate makes loans cheaper. How?

Using our last example-

  • Your loan is Base rate + 4%
  • Base rate before the Brexit referendum was 0.5.
  • Your loan- 0.5+4%, you are paying 4.5% interest on your loan.
  • Base rate post Brexit is cut to 0.25.
  • You loan is Base rate + 4%,
  • Your loan- 0.25 + 4%, you are paying 4.25%
  • So you were paying 4.5%, now you are paying 4.25%, so you will be very happy with the base rate cut. If you have a lot of debt or want to take out a loan but aren’t too sure, big cuts to the base rate will help you.

However, it also means less money is generated by interest. So if you are a millionaire living off the interest in your accounts, you might be cursing a base rate cut.

Cut the base rate to encourage growth and innovation if the economy is stagnant. It makes loans and financing cheaper, so people are more likely to do it.

Why increase the base rate?

If the economy gets too hot, it may need to cool down. People are spending too much, taking out too many loans, the whole thing is just overheating and barrelling forward (think before the 2008 crash). You can allow this to continue but history has shown it results in an extreme crash and even depression. Some countries are okay with this but most aren’t.

Pushing up the base rate makes it better to sit with savings (you get more interest), it makes loans, credit cards etc more expensive, so you will see less start ups and risky business moves.

Think of it this way, making it more expensive to expand and grow lets everyone catch their breath, cool their heads and consider what they are doing. The Bank “takes away the punch bowl when the party gets too crazy” is the analogy I frequently hear.

Let’s use the previous example again.

  • Your loan is Base rate + 4%
  • Base rate is 0.25.
  • Your loan- 0.25+4%, you are paying 4.25% interest on your loan.
  • Base rate is increased to 1%.
  • You loan is Base rate + 4%,
  • Your loan- 1 + 4%, you are paying 5%
  • So you were paying 4.25%, now you are paying 5%. It will take more of your resources to pay for that loan, you will be less inclined to take out more loans or take riskier ventures. You bide your time for a year or two until the base rate is lowered again.

 

What to take from this blog?

The Bank of England website shows all the times the base rate has changed and it isn’t as frequent as you might think. When the base rate change does happen, it will be an attempt to guide the economy. So if a newspaper screams the end is nigh because the base rate is cut, if you have a lot of loans or want to take out a loan, you would actually be pretty happy about that. If you make your money from the interest on your deposits, you would be very annoyed by this.

If the base rate is increased, yes it makes financing more expensive and puts people off loans, but it can also be a good time to stay still and catch your breath a bit, see some decent interest on your savings and bide your time.

I can’t stress this enough, a base rate cut or rise will be good or bad for different people- neither is universally a bad thing.

Further reading

This is a pretty fundamental banking concept, try any university level coursework book and it will go into further detail.

 

Banker Blog #1 What does “too big to fail” mean?

“I hate banks. They do nothing positive for anybody except take care of themselves. They’re first in with their fees and first out when there’s trouble”

Earl Warren, American jurist and politician, who served as the 30th Governor of California and later the 14th Chief Justice of the United States.

I couldn’t disagree with Earl Warren more. Banks provide loans to get businesses off the ground, they give people a place to keep their money other than their mattress, they give people credit and the ability to manage their finances, they work with the police to clamp down on fraud, they work with governments to try and tackle money laundering. I could go on and on.

In the first of a series of blogs on misunderstandings with the banking sector, I wanted to take a break from writing advice to look at “too big to fail” an often used term.

You see it in the news, on internet articles, but what does it really mean?

In the UK we normally refer to the big four, the four largest banks in the country. The Royal Bank of Scotland, HSBC, Lloyds Banking Group and Barclays. It is different in other countries, some may only really have one, others can have hundreds.

Let’s say very broadly they are of roughly equal size, each holding about 25% of the public’s money. Not stock brokers or investment houses, just Joe public and their bank accounts.

If any of these banks were to fail, and the government allowed it to collapse, a quarter of the people would see their savings lost. Imagine the chaos that would plunge the country into. The economy is an interlinked machine, the horror doesn’t end with that. A quarter of the people have less money to spend in restaurants, can’t buy games, can’t buy books, can’t buy cars, so all those industries take a massive hit.  The decline in confidence in the banking sector sees the other 75% of banks struggle against a hesitant public, those failing industries default on their loans and can’t make payments.

A bank of that size collapsing, even one, without exaggeration can ruin a country.

So during the financial crisis of 2008, when some politicians sneered that some banks should be allowed to collapse because there were still others left really didn’t understand the full impact that would have.

That is what too big to fail means. These banks are so gigantic, so totally intertwined with the economy, that if they were to be allowed to fail as a result of their own poor decisions and management, the entire nation would suffer.

No government would allow this to happen for two reasons. Number one, it is safe to say a lot of people in politics do actually care about their fellow citizens. Not all, but a fair amount. They don’t want the people to have to go through that pain. Number two, let’s say you don’t care at all about the suffering of others. Okay, fair enough. But you can kiss re-election goodbye if you allow this to happen, you have to save the bank or your career in the public domain is dead.

Solutions?

  • Financial Services Compensation Scheme

This ensures that up to £85,000 of your savings is guaranteed, even if your bank fails. For some people, this covers their entire savings or at least a majority of it. This means government can be bolder in allowing a bank to fail.

  • Ringfencing

This means that the risky, investment side of banking is broken off from the main bank. This was one of the problems with too big to fail, the folks gambling on the stock market could arrogantly do so because even if they lost all the bank’s money, the government would top it up because if the bank fails, the retail side goes down and people lose their deposits.

Ringfencing breaks it into two. Firstly, the safe, so called “boring” retail and commercial side of banking, focusing on bank accounts, deposits, lending to people and companies (where yours truly earns his daily bread). Secondly, the risky, stock market wheeling and dealing, high risk investments.

So if the investment bankers decide to go crazy, their organisation is separate from the main bank and can be allowed to fail without impacting the public.

  • Force the big four to break up

I disagree with this solution but I have seen it bandied around, most prominently in the run up to the last election, with Labour leader Ed Miliband touting it. Not as disastrous as the Ed Stone (https://en.wikipedia.org/wiki/EdStone)  but not one of this better ideas.

I fear that forcing in organisation to break into ten separate entities could result in several underfunded, undercapitalised and underprepared banks trying desperately to stay afloat and most likely failing.

I haven’t seen any concrete or well articulated reason why this would work yet so I don’t support it.

 

What to take from this blog?

Too big to fail is not a permanent part of banking, it is actually a fairly recent phenomenon, brought to a head in 2008 after a period of insane growth driven off subprime mortgages at the height of an investment bubble.

Despite what some commentators may say, It is not a permanent addition to the banking world and  steps have already been taken to ensure that if a bank makes poor choices, it is allowed to collapse, as it should.

 

Further reading

Too big to fail by Andrew Sorkin

Shredded: Inside RBS the bank that broke Britain by Ian Fraser

Hubris: How HBOS wrecked the best bank in Britain by Ray Perman