Bank Runs

“XYZ bank is going to become insolvent, get your money out.” Said Dev in a concerned tone to me. This was a few months back if you remember. In short that is a bank run for you. As it progresses it generates its own momentum and becomes a self -fulfilling prophecy. This can destabilize the bank to an extent that it might as well be staring at bankruptcy.

But then you may be tempted to ask after all where did the money go? What’s the problem in returning it to the depositors? You are right, but first we need to understand the function of a bank.
Banks are intermediaries between savers who prefer to deposit and borrowers who prefer to take out loans. Thus they provide a valuable service by channeling funds from many individual deposits into loans for borrowers. The problem occurs in the timelines that we set for our deposits and the timelines set by borrowers for their loans.Generally business investment often requires expenditures in the present to obtain returns in the future (for example, spending on machines and buildings now for production in future years). Therefore, when businesses need to borrow to finance their investments, they prefer loans with a long maturity (that is, low liquidity). On the other hand, individual savers (both households and firms) may have sudden, needs for cash, due to unforeseen expenditures. So they demand liquid accounts which permit them immediate access to their deposits (that is, they value short maturity deposit accounts). Under normal circumstances all goes fine since savers unpredictable needs for cash are unlikely to occur at the same time.Thus a bank can make loans over a long horizon, while keeping only relatively small amounts of cash on hand to pay any depositors that wish to make withdrawals.

Now, if all depositors attempt to withdraw their funds simultaneously, a bank will run out of money long before it is able to pay all the depositors. This means that even healthy banks are potentially vulnerable to panics.So what is the solution?

Insurance is a nice concept that comes into picture over here.Say the government was to insure your deposit, that is if the government was to promise that no matter what happened you will get your money back. Thus you now have no incentive to participate in the bank run. Now that all or atleast most depositors would think on the same lines thus almost wiping out the probablity of bank runs. What an elegant solution!! Are we missing something?

Well yes, though we have solved the original problem we have introduced a new one. Banks which took the risk now come to believe that they will not have to carry the full burden of losses. The government is there to take care in case things turn sour.Now will this make the bankers aggressive lenders? Will they lend to any Tom Dick and Harry (read sub prime borrowers ) who do not have enough resources to pay back the debt.I bet they will. We were trying to make our deposits safe but it turns out we have just made it all the more unsafe without realizing it. Any ideas to get out of this ? Keep posting.

Cheers !!

Feedback loops

Sometime back i visited a birthday party (that of my colleagues son) and was flooded with the memories of those good old childhood days. After all it has been ages since I went to such a birthday party.

One thing that I noticed in particular was the Hot-Cold game. As a kid I have played it a lot, in case you haven’t then here is a small description. You leave the room and your friend hides an object somewhere. Then you come back in and you try to find the object
while your friend gives you feedback. You head towards the sofa and look under the cushions and your friend says, ”cold.” You then move away from the sofa and head for the bookshelf. Now, your friend says, “warmer.” You keep searching around the bookshelf and eventually you find it. In other words, you use your friend’s feedback as
information about whether to continue on the path you’re on or whether to change course. So when does the game end? It ends when you find the object. Sure, you could
give up the search, but most of the time, that doesn’t happen. It may take a long time to find the object and your path depends on where you begin your search, but most of
the times, eventually, you do find the object.

Now let us take this model and apply it to the very concept of goal. Most of us have one goal or the other which when we don’t achieve, we see failure. Instead we should be seeking feedback. Every time you do not achieve what you wanted to, see it as a feedback that your friend gave you when he said “cold”. Don’t give up. There are others who persist. These strong souls jump right back and do the same thing again. Again apply the model. Will you keep looking around the sofa even after your friend said “cold”? Obviously not. Yet people do the same thing that results in frustration and anger. So from now on when you set a goal listen for feedback. Listen carefully and you will sure hear “hot” or “cold”. Adjust your next move accordingly and keep moving. There is no failure only feedback. Keep trying and you will sure reach your goals. :)

Puzzled!!!

I have a very interesting puzzle for you today.The most salient feature about this puzzle is the simplicity of it.You might be tempted to say that there is no serious or practical answer to it.But i warn you that it is not the case and you will definitely scratch your head once you figure out the answer in complete amazement.So here we go ...

Say one day you get a mail from some self proclaimed finance pundit extolling
his powers of predictions about the mad mad stock market.He gives a "tip" saying that a particular stock A will go up by say 10% in a month's time. You dismiss him as one more analyst,finance guru or nerd who have an opinion on all the matters of finance without having an ounce of knowledge.So a swift shift delete and the mail vanishes from your inbox.Now a month has passed and over a mug of beer a friend of yours tells you how he made 10% by buying stock A following the advice given in an email.A bulb glows somewhere at the back of your head.You wait for this unknown oracle to speak again.Soon another email registers itself in your inbox.It highlights its previous prediction and gives one more tip for this month.Though excited your skeptical self prevails and you dismiss the whole episode as a chance coincidence.Another month passes by and you again hear from this stranger. He emphasizes the corectness of his last two predictions and gives you one more tip for this month.You sure are amazed.A quick search and you verify the results of the last prediction.So you hear yourself saying "Well maybe this fellow really knows something.Lets check him out." You eagerly track the latest stock and soon see his prediction coming true.Voila!!. You have discovered a goldmine dude.You swear to yourself "I am not going to miss out on the next tip.Lets make some money."
Sure as if you are having a telepathy with this oracle and one more mail makes its way to your inbox.Another tip and you are all geared up.Like a smart investor you put a small amount of money on the stock this fellow has recommended and after a month find to your satisfaction that you it was bang on target.God is really happy with you son.But then all of us have heard "There are no free lunches."Are they??.So the next mail summarily says its time to put some serious money on the table to subscribe to his "tips".Afterall you would have made a small fortune by following his tips.So you agre and write him a cheque and wait for the next tip.There it comes.Already your eyes are green with greed.You have hit a jackpot.You are dreaming of that latest cell phone that you saw your boss carrying.You promise your girlfriend a diamond necklace soon.This is your chance,so you go full throttle on this one.Put all your money on this bet.Maybe borrow some from your friends and put it on this stock.
Now neither am i a sadist nor a hindi film script writer,but your good days have come to an end.This tip turns out to be wrong.Ahh,heart broken you feel like banging your head as well as of that fellow who lead you to this misfortune.In a contemplative mood you look up at the sky and ask GOD with disdain "Why me?".You try to reason with yourself, "I had tested this fellow.It was not that i followed his tips blindly.I waited for months and saw the results before i put any serious money." So what went wrong? Yes, that is the puzzle."What went wrong and how?"

Now you might say this was plain luck,maybe chance coincidence.But i warn you against these thoughts.There is a very logical pattern behind this whole scenario.Whack your heads,go get yourself a cup of coffee.Maybe you should light your favourite smoke before you wrestle with this puzzle.Do whaatever that needs to be done to get those creative juices flowing for there is a very logical answer.A simple yet such a powerful model that it fooled you so easily.

Well i will leave you with that.Will post the answer in a few days.Till then good luck to all of you.Keep posting your answers...