Part A: The Inside Story

Universal Theory Part A: "The Inside Story" – The Universal Theory of Commercial and Investment Banking, Financial Market Players, & their Regulation

  • Problem: The modern financial system is not well understood.
  • Mission: This record exhaustively explains the theoretical basis of functions and issues relevant in modern financial systems, including the central bank’s role of regulation.

    • Reality Check: Will attempt to, but is not responsible for matching theory, which necessarily holds true, with real world, which offers relationships that change constantly and has rampant problems with terminology.
  • Goal: Reader should have a sound theoretical (but also realistic) understanding of how the modern financial system works.

Intro para

  • A Rose by any other name. "Banks", here, don’t necessarily mean those with a bank charter, it means Fin intermediaries that have cbanking and ibanking business models – e.g. Mafia bosses, your rich uncle, FI’s that provide car, student loans do specialised segments of banking but are not formally banks. However, their activity and impact on the economy cannot be ignored.
  • Financial Intermediaries: All Banks serve as an intermediary between borrowers and savers, charging implicit and explicit costs.
    • Implication: Depending on factors like regulatory environment and other implicit/explicit costs, lending activity will shift between these two modes. Lending activity is not exogenous to these "costs", but it is certainly partially exogenous, being also determined by cultural preferences and monetary policy (see Theory of MP).
    • Commercial Banks intermediate through maturity transformation.
      • Commercial Banks lend out (100%-reserve ratio) of the money from depositors, paying low rates to earn high rates
        • Weakness: by design, they have more short-term liabilities than ST assets, or negative working capital. By design, highly leveraged.
          • Basel II agreement set out world standard for CBank liquid assets
          • Regulation: Deposit guarantees, Lender of Last Resort (Lombard) Facilities
            • Tools: Usage of Repo agreements as superefficient ST lending collateral
      • Segments of Cbanking
        • Banks "Too big to fail" have implicit govt backing – low borrowing rates
        • Money flows between banks
      • Risk management practices include credit assessment as well as collateralized lending.
      • In general, CBanks earn spreads, not fees.
    • Investment Banks intermediate through the financial markets, helping savers directly invest in borrowers.
      • Implication: Not leveraged by design.
      • Risk management practices include
      • In general, IBanks earn fees, not spreads.
  • Other Financial Institutions
    • Individual Investors, Pools of Money, & Money Managers
      • "Retail" Investors & their "Sophisticated" Brethren
        • Pension Funds
        •  
      • Mutual Funds & Hedge Funds
      • VC/PE Funds
    • Service Providers
      • Advisories
      • Brokerages (also included in Financial Intermediaries)
      • Researchers
      • Financial Criminals ("paid" to take away your money) e.g. Ponzi schemes
    • Insurers
    • Pension Funds
  • Financial Regulation
    • Cbanks
    • Ibanks
    •  
    • The "Integrated Regulator"
      • What this stress test has done is given the regulators a broader perspective to say, "Is this institution sound? How does it compare to other institutions? What’s happening in the broader financial landscape?" (source)
  • Reality Check
    •  LIBOR-OIS spread, which is a key measure of risk in the financial system. Typically, 5 – 10 basis points,
    • "Investment Banking ceased to exist" – wrong. Formal IBanks remain outside the US. Within the US, for example, GS still does not do CBanking – it converted to a bank holding company only in order to access Fed funds (Legally, Fed has no jurisdiction over Ibanks).
  • tbc