Part 7 switzerland - forum nexus finance class summer 2011

Forum-NexusWelcome to Switzerland!!

Brian David ButlerProfessor of international finance and global entrepreneurship with Forum-Nexus Study Abroad. Guest lecturer with the IQS Business School of the Ramon Llull University in Barcelona, and the Catholic University of Milan. Previously, Brian taught finance, economics and global trade courses at Thunderbird’s Global MBA program in Miami, and worked as a research analyst with the Columbia Business School in New York City. Brian currently lives in Recife, Brazil where he is teaching classes on “Global Entrepreneurship” at the university FBV.

A global citizen, Brian was born in Canada, raised in Switzerland (where he attended international British school), educated through university in the U.S., started his career with a Japanese company, moved to New York to work as an analyst, married a Brazilian, and has traveled extensively in Latin America, Asia, Europe and North America.

[email protected]

LinkedIn/briandbutler

Skype: briandbutler

Find my slides:

www.slideshare.net/briandbutler

Midterm Exam material (potential)

• Students responsible for content from:

a) Prof. Brian’s lecturesb) Guest lecturesc) Group discussions during classd) International IQ sessions (including map)e) Professional Visitsf) Assigned readings – book

•Notes:• Exam questions may come from any of these sources• Recommended exam review – pay attention to my lectures. If there is

something I think is important from professional visits, or international IQ sessions, or from the book…we will try to review it again in class.

Expectations:

▫Attend classes – exams will be from lectures, from assigned readings and from guest lecturers/ professional visits

▫Turn in assignments before class ▫Be prepared for class discussions – lots of small

group assignments during class▫Contribute to group assignment (team grading /

peer review)▫No sleeping, no laptops, no phones (sorry) ▫If your tired… standup, go get a drink, come back

Required books

•Required Textbook▫'An Introduction to Global Financial

Markets', by Stephen Valdez, Palgrave Macmillan, 5th Edition, 2006

▫'Fixing Global Finance', by Martin Wolf Yale University Press, updated 2010

Assigned Readings

•Martin Wolf book

▫Final chapter (ch 8) “From Imbalances to the Subprime Financial Crisis”

▫Recommended: First four Chapters

• Finance book

▫Chapter 10 – foreign

exchange ▫ Chapter 11 - European

Economic and Monetary Union▫ Switzerland – p 288▫ Euro – p 289, p304

• Optional additional reading▫ Chapter 2 – banking

background p30-38▫ Chapter 6 – the money and

bond markets▫ Chapter 12 – traded options▫ Chapter 13 - Futures

review

•Discussion

Discuss Switzerland/ Euro / crisis…

•Articles? Observations? Discuss….

•Note: observations should come from reading (wall street journal, etc)… any other sources?

Themes to cover:

1.Banking Business Model –continued

2.Finance: “Pyramid of Promises”

3.Fixed, Flexible currencies

4.Mundell Trilemma

Solvency v Liquidity

•Who can remind me…

•What is the difference between:•a “Solvency” problem (for banks)•And a “Liquidity” problem (for banks)

•* think of the business model

Solvency v Liquidity• Insolvent: liabilities > assets (equity = 0)

▫Person: I owe more than Im worth▫Bank: assets loose value (subprime mortgages)▫Country: cant pay debts…default

• Illiquidity: long term asset, short term liability▫ I owe money NOW, but have money tied up in my

house, car, etc…▫Bank: lend long term, borrow short term▫Country: cant access credit markets to pay

imports

Solvent: not Solvent•Ok NOT OK

ASSETS-Include home mortgages-subprime

Liabilities (Borrowing, debt)

Equity



Equity

Response: “Almost all independent observers of Greece have stressed from the beginning that Greece was facing a solvency, not a liquidity problem. This was also the case 10 years ago with Argentina; a country that had achieved financial stability by entering into a “quasi” monetary union using the US dollar and which had privatised every available public asset.

PIMCO CEO Mohamed El-Erian

“the Greek government is losing control of the streets. As protests turn increasingly ugly, the pursuit of a national political consensus becomes even more elusive. This is especially true if all Mr Papandreou, or another leader, can offer is a step back to a discredited approach that involves sacrifices with no evidence of lasting benefits.”

PIMCO CEO Mohamed El-Erian

Solvency v Liquidity

•How does this relate to the Financial Crisis 2008 (US)?

▫Anyone?

Solvency v Liquidity Timeline

•2007 – September 2008▫Problem = Solvency▫Mortgages (assets on

Banks balance sheet) worth less than anticipated… write down

▫Results: Hedge funds Funds go under (Bear Stearns)

▫Bankruptcy threat



Equity

Credit bubble led to housing bubble, led to bust…

http://www.abc.net.au/reslib/200802/r220644_867185.jpg

Credit Crisis timeline – key dates in SeptemberSeptember 7, 2008: Federal takeover of Fannie Mae and Freddie Mac

[25][26] September 14, 2008: Merrill Lynch sold to Bank of America amidst

fears of a liquidity crisis and Lehman Brothers collapse[27] September 15, 2008: Lehman Brothers files for bankruptcy

protection[28] September 16, 2008: Moody's and Standard and Poor's downgrade

ratings on AIG's credit on concerns over continuing losses to mortgage-backed securities, sending the company into fears of insolvency.[29][30]

September 17, 2008: The US Federal Reserve loans $85 billion to American International Group (AIG) to avoid bankruptcy.

September 19, 2008: Paulson financial rescue plan unveiled after a volatile week in stock and debt markets.

September 25, 2008: Washington Mutual was seized by the Federal Deposit Insurance Corporation, and it's banking assets were sold to JP MorganChase for $1.9bn.


•September 2008 – 09▫Crisis CHANGED▫No longer just a SOLVENCY CRISIS▫Became a MIXED crisis of BOTH solvency

and liquidity▫How? Why? What does that mean?

▫Someone tell me again…what is “liquidity”?

Questions:

•Question: if a bank is having a SOLVENCY trouble… should the government come to their rescue?

• (clue – remember the discussion on “moral hazard”)



Equity


•Answer: NO! (probably not) *

•* but, gets complicated by worries about systemic risk, and interconnectedness, and “too big to fail” banks



Equity

How about a “Liquidity” crisis?

•Should the government step in to help a bank facing a “liquidity” crisis?

How about a “Liquidity” crisis?

•YES!!•To help banks bridge the gap between short term liabilities and long term assets

•* this is exactly why the FDIC, insurance was offered.

The trouble during the crisis…

•… after September 2008… it was difficult to tell which banks faced “liquidity” crisis (and should be helped), and those that faced “solvency” crisis, and should be allowed to fail (to avoid “moral hazard” from saving them)

•PYRAMID OF PROMISES

International Finance

Pyramid of promises

What “promises”?• Financial assets represents “promises of

future, often contingent, receipts in return for current payments”

• Bonds▫Represent PROMISES of fixed payment (in

time), plus PROMISE of regular payments in between

• Equity (stocks)▫Represent PROMISES a share in future

corporate profits• Pensions

▫Represent PROMISES for a stream of income in retirement

Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005

What “promises”?• Life Insurance Policy

▫Represent PROMISES of payment after some fixed date or death

• Accident / Health Insurance Policy▫Represent PROMISES of payment if something

happens• Mutual Fund

▫Promises to return to investors the proceeds from mutual funds purchase of promises from corporations

• Options▫Is a promise to hand over a claim to a certain

promise under specific conditionsMartin Wolf, “Fixing Global Finance”… based on

McKinsey “Mapping Global Capital Markets”, 2005

Remember 2 dangers of international finance…

1. Currency might devalue2. Foreign governments might default (less

obligation to foreigners, not to voters)

* Promises based on trust

Pyramid of Promises

•“Central feature of the financial system: it is a Pyramid of promises- often promises of long or even indefinite duration. This makes it remarkable that sophisticated finance systems exist”

•Promises may not be kept•Interest of those who make promises NOT

to keep them


Pyramid of “promises”?

•“As the financial system grows more complex… it piles PROMISES on PROMISES”.


Just how big is the MOUNTAIN of promises…?

•Amazing….

data from McKinsey report 2005, "Mapping the global capital market" and http://www.federalreserve.gov/releases/


Size of Finance…

•“What is amazing is that the financial sector ballooned to the size that it has...with a worldwide total of $140 trillion in promises outstanding in 2005”


Size of Finance…

•Of that total, the US was the prime holder of promises (assets).

•The US household sector held about $39 trillion (28% of world total), and with the US as a whole holding nearly $52 trillion (37% of all world financial assets, or promises).


Size of Finance…


“PYRAMID of Promises”


•Modern economies depend on pyramids of promises far more impressive and complex than those of stone constructed almost 5 thousand years ago”

“PYRAMID of Promises”


•But, the system is extremely FRAGILE

•Confidence that sustains them could be misplaced

•People could end up with promises NOT WORTH the paper (they used to be) printed upon

Underneath that “PYRAMID”


•The “Foundation” of all of these PROMISES is = title to real assets▫Housing, land, property, factories,

machines, etc

▫Need to BELIEVE the original owner really ownes what they say they own.

▫So, key = property rights, law, institutions – for trust, and development of financial system

Fixed, Floating

FX discussion…

Dr. Kishore Dash, January 20, 2007

Exchange Rate Practices

•Pegging

•Floating

Exchange Rate Options

OfficialDollarization

CurrencyBoard

Free Float

Peg

More Flexible Less Flexible

Crawling Peg

BandDirtyFloat

Source: Rafael Barraza

Dr. Kishore Dash, January 20, 2007

Fixed vs. Flexible exchange rates

• Fixed exchange rates▫Any examples?

• Floating exchange rates▫Any examples?

• What system is active today? (globally)

• Important to INTERNATIONAL business managers to pay attention to changes▫why?


•What system is Better? Why?

▫Groups of 2-3 students, answer

Brief History – Key points

•Key point: there is NO “best” system•It all depends on what you want to

achieve…•History: Cycle from Fixed to Flexible to

Fixed to Flexible……(future?)

Fixed Fixed

Flexible Flexible

The gold standard (~1850–1914)Fixed exchange rates during the 1920s

Great Depression era

Post WWIIBretton Woods / IMF system (1944–1971)

1970’s –today: since U.S. left the gold/dollar standard

?????


•QUESTION:▫Why change from flexible to fixed? (give 1

reason)▫Why change from fixed to flexible?

Fixed Fixed

Flexible Flexible


Inter-war periodGreat Depression era



Brief History – Key points• ANSWER:

▫Why change from flexible to fixed? CONTROL, STABILITY, LOWER INFLATION,

END CHAOS Note: Too chaotic in depression… so fixed for

stability Note: Argentina = fixed to dollar was “brilliant”

at the time…but should have dropped sooner (not just in 2002)

▫Why change from fixed to flexible? EASE ADJUSTMENT PROCESS, IMPROVE

LOCAL MONETARY CONTROL, INCREASE GLOBAL FLOW OF FUNDS

FIXED system…

Painful ADJUSTMENT mechanism:

Example: Under the GOLD Standard:

If exports > imports… build up gold reservesIf imports > exports… run out of gold reserves

KEY QUESTION:

▫ Under a fixed system, how do you increase exports? (to stop burning through gold reserves)?

▫….Group answer

FIXED system…

Answer▫ need to decrease prices, wages ▫ So exports more competitive▫Can’t adjust FX rates, so adjustment has to be painfully with wages, prices

• KEY POINT:▫ adjustment in fixed system is = painful process, slow, very unpopular!▫

FIXED system…

KEY QUESTION:

▫Under a fixed system, how do you increase exports?

▫….Group answer


•What system is Better? Why?

▫Groups of 2-3 students, answer


•Key point: there is NO “best” system•It all depends on what you want to

achieve…•History: Cycle from Fixed to Flexible to

Fixed to Flexible……(future?)

Fixed Fixed

Flexible Flexible


Great Depression era



?????

Part 7 switzerland - forum nexus finance class summer 2011

Economy & Finance

Transcript of Part 7 switzerland - forum nexus finance class summer 2011