You might have watched the movie “The Big Short” and understand how one of the biggest banks in financial history was taken down within months from an overexposure to the debt market. Simply put, the big boys (read: “fat cats”) were not getting their money back from those (debtors) they had lent out to, and Big Brother Lehman was not getting a bail out. So who were the debtors? They were mostly made up of average folks like you and I, who had big dreams of owning a home way beyond their means. Banks and financial institutions were betting on the prospect of a booming property market. As property prices soared, the banks became even more lenient when assessing their borrower’s capacity / creditworthiness. This, of course, turned out to be one big mistake!
September of 2008 was an unprecedented catastrophe in financial history, with markets falling beyond levels seen in 1929 (Great Depression). Guess we could call 2008 the “greater depression”, eh?
This article will not attempt to explain how the debt bubble and irrational exuberance led to the imminent sub-prime crash. However, it serves as a premise to illustrate how the monetary system has changed ever since.
Traditionally, the central bank of a country / region can do one of three things to manage the money (or credit) in circulation;
Open Market Operations
The central bank (i.e. MAS) can control the money supply by buying or selling securities, usually in the form of bonds (debt), to the country’s private banks (i.e DBS). If the MAS buys bonds from DBS, it gives DBS more liquidity to lend money to others (i.e. retail, commercial clients).
*Illustration: DBS issues a contract stating it will borrow $100 from MAS, MAS buys the contract and pays $100 to DBS. Now DBS has $100 more in the cash account to run their business activities. Of course, DBS will have to pay this money back upon maturity of the contract.
The buying of bonds by the central bank is called an expansionary monetary policy.
Required Reserve Ratio (RRR)
The RRR states the percentage of deposits (from clients) a bank must keep on hand overnight. A low RRR would allow banks to lend out more of their deposits, thus expanding the economy by creating more credit. However, a high RRR would contract business activities for the banks as it reduces their capacity to lend out money. Banks must borrow money from one another or from the central bank if to meet the daily RRR if they run a deficit.
Illustration: The RRR is 10%. If Bank A has $1000 in deposits, they can only lend out a maximum of $900. If the RRR is increased to 20%, the bank can only lend out $800, which means they will earn lesser as a result of a higher RRR.
The is the interest rate that a central bank charges its members (banks) to borrow. As the discount rate is usually higher than the inter-bank offered rate, banks only resort to borrowing from the central bank at the discount rate if they are unable to borrow funds from other banks. It is seldom to see a central bank drop the discount rate to induce borrowing from its members. More often, it will focus on Open Market Operations and managing the inter-bank offered rates.
Artificial means of “priming” the economy
After the 2008 crisis, central banks around the world thought of an ingenious idea to “defibrillate” the economy by flooding it with excessive amounts of credit. This strategy was termed Quantitative Easing (QE). To cut through all the BS, QE was just a way for central banks to print money and double the rate of the asset purchase (bond buying) programme. In essence, QE is Open Market Operations on overdrive. Central banks were printing billions of dollars and increasing the amount of credit in circulation. The greater money supply decreases the value of our fiat currency, driving up the rate of inflation. It hasn’t been easy for the central banks to ease the the asset purchase this past decade. While the US Central Bank (Fed) has aggressively tapered the QE, the European Central Bank (ECB) has just started discussions about the possibility of tapering within the next year. Economic data has been pointing towards a progressing economy, but remains fragile. Central banks have to be very strategic in pulling out the “life-support” they have been giving since 2008.
ABOVE: Janet Yellen, Chairperson of the US Federal Reserve – known to be”hawkish” in her approach, she thinks US is ready to be taken off “life support”.
The big question remains; have we really recovered from the 2008 crash or is it just an illusion that stems from well-orchestrated policies of the central banks. While it is not my intention to determine whether the bull rally in the stock market from the 2008 low to where we are right now (S&P 500 above 2,400) is justified, I believe it is imperative to understand the underlying forces that drove markets up to such levels. A good mix of cheap money, induced inflation and optimism took us through a decade since the crash. But how far can we really go with this? Will the economy stay buoyant even after the central banks have raised rates back to normalcy? Nobody knows.
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Till next week, have a good weekend!