Banking is a proxy business, providing a virtual segregation out of single account by using different accounting books.
Say, - Swiss private bankers have many accounts for customers, but actually they have only one bank account in a bank.
- Citibank Singapore has many accounts for customers, but Citibank has only one account in the central bank.
Again, banking is a proxy business, creating virtual segregation through bookkeeping, and creating many accounts for customers, based on one account.
Theoretically, this virtual segregation of accounts can be automated. To make it simple, let us focus on only deposit account. So long as the summation of the virtual deposit accounts outstanding is equal to the source account outstanding balance, we can keep splitting one account into two accounts by adding unique identifiers (new book names). Also once we delegate the ability to split the accounts to create new accounts, practically, we are delegating the banking capability (proxy capability).
So suppose, we set up an internet bank (B1) in U.S. having one central bank account at the Federal Reserve Bank. The internet bank (B1) has a button to click, "create a bank". Once click the button, it creates another bank (B2) by splitting the central bank account of (B1) virtually.
(B2) has the same button "create a bank", so we can split the bank account of (B2), to create the third bank (B3) and the fourth bank (B4) so on.
This process is recursive and it can continue infinitely, creating a tree structure with the root node of the central bank account. This can be fully automated by a program, just keep adding a new bank node out of the existing bank node.
The benefits of this virtual banking system are:
1. All the customers are sharing the same central bank account virtually, which has no credit risk. No need to worry about if banks are safe or not. Once this system is in place, people might wonder looking backward, why we used to have the intermediaries just to create credit risk (bank default risk).
2. There is no human intervention. This is just a system. All we need is just direct linkage to the authority which has the right to print money, and automated way to keep sharing the access to the monetary authority.
3. This is great one step forward in human history, to delegate the access to the safe place (no credit risk), to each individual level. And there will be less reason to inject tax payers’ money to those too big to fail.
This idea may sound a bit funny at this moment, the world economy, however, is getting more volatile with the advancement of financial technologies. And once we saw a very big economic crisis, such as, Japanese Government bond default triggering massive sales of US treasury, so on, securing the access to the place where individual can safely place their money on, will become a higher priority for sure.
Also there might be a concern over money laundering, with this proxy idea. But the reality is, banking is proxy business by its nature, as having one account in central bank and transfer money within the central bank. In addition, Banks are trying hard, with KYC (know your customer), but sometimes even official identification documents can be purchased in third countries at very cheap price.
The formula 1) does not make sense as each unit (time & length) is different.
This means that addition/deduction is valid only for the same unit like,
2) 10 hours + 10 hours = 20 hours
On the other hand, Multiplication and Division are applicable to different units.
3) 10 meter / 10 minutes = ?
The answer is 1 khr. And Khr is a new unit (concept) called “velocity”
Unit is for concept. And Multiplication and Division are tools to create (define) new concepts. Whereas, addition/deduction are not.
Another example is
4) 10 meter * 10 meter = ?
The answer is 100 squared meter. In this case, length becomes a new concept "area".
Therefore, whatever formula in mathematics equation, say A/B + C*D. The key to understand is, A/B and C*D are the same concept (unit). “/” and “*” are operations to make the two to be the same concept (whether the equation is correct or not is a different issue).
Additionally, mathematics is a science with no unit. It is a science of numbers (concept), detached from unit (concept), so called Meta Concept. And this is the reason it can be applied to many phenomena of the nature.
Accounting defines profit. There are no investment activities without profit. Without profit, there is no capitalism. Therefore, accounting is the foundation of the capitalism.
For profit calculation, we need a robust recording system. The recoding tool is called the double bookkeeping system. Surprisingly, this recording tool never changes more than 500 years in its principle.
This presentation goes through the process how the financial statements, which measure our corporate performance, are generated,and understand the functionality of the double bookkeeping system.
2. Agenda:
Double bookkeeping system. As it called “system”, it is automation and processes enforcement.
Balance Sheet (BS)/ Profit Loss statement (PL). These are called financial statements. Financial statements are the outputs of the double bookkeeping system. Therefore, changes on the financial statements will impact on the mechanics of the double bookkeeping system. This is similar to computer system. If output changes, the internal mechanics of the computer system has to change.
These two are linked. Financial statements are the output of the double bookkeeping system.
3. History of Accounting:
A brief history, the first accounting book was written by Luca Pacioli during Renaissance time. Luca is a close friend of Leonardo da Vinci. As the book title indicates, “Summary of arithmetic, geometry, proportion and proportionality”, this is a mathematics book. The reason why the first accounting book was written as mathematics book is, mathematics and bookkeeping were written in the same format, sentences and paragraphs. Sciences were not branched out still.
4. Double Bookkeeping system:
Double bookkeeping system is a great human invention, just like mathematics. This is because double bookkeeping system allows users to do recording, tracking, calculating, reporting and checking without understanding how accounting works, so long as following pre-determined steps and formats. This is an analogy of a computer system. We can use computer system, without understanding how it works.
5. Account Origin (1) :
Let us start with “what is account” to understand the double bookkeeping system.In Ancient Rome, lending money is not accepted moral with citizens, therefore handled by non – citizens. The initial form of bookkeeping was recording “I owe you” and “you owe me”, i.e. debtor and creditor.In this context, accounts are personal names. Debit and Credit have the original meaning of debtor and creditor.
6. Account Origin (2) :
After Industrial revolution, economic activities evolved significantly. Accounts are no more personal, but can be anything. The key observation on this slide is, “profit/loss” account. This is purely conceptual, doing profit calculation. Accounts are detached from the context of debtor/creditor. Debit and Credit simply mean left and right in modern days.
7. Book Structure:
The next few slides are to describe the interface of the double bookkeeping system with a simple example.
Books are just notebooks. Ledger is a book recording financial information, which can have multiple accounts. Ledgers are a part of the double bookkeeping system which means to say it can impact on the outputs i.e. financial statements, whereas Journal and Daybook are not. Journal and Daybook used prior to Ledgers.
8. Journal / Daybook:
The usage of the sales day book is, first, sell products on credit by issuing invoices. Second, record date, invoice No and amount of the transaction. At this stage, The Folio column is blank. Finally, once the transaction information is posted to Sales ledger, fill out the folio to indicate to which ledger being posted. Since Sales ledger is also another notebook, it is important to note which page, in this case, the page fifteen (SL15) for traceability.
9. T-Account (1):
C Knight and D Mike are account names in the Sales Ledger. All the four sales of the previous slide were posted on the left hand side. On the right hand side, there is an entry of Bank $200, indicating C Knight has paid $200 on the Aug 28th.
At the end of the each financial period, we need to close off the balance for reporting. The steps to close off the account are 1, calculate the total amount of each side, 2 calculate the difference between the two sides, and post the difference as balance carried down to balance off. 3 the double lines indicate the amount 300 is “total amount” and the single line is meant to say “account is closed”, 4. Post the balance brought down for the next period.
Account is called “debit balance”, when the balance B/D appears on the left hand side. And account is called “credit balance” when the balance B/D appears on the right hand side. If balance does not appear on the either side, it is called zero balance.
10. T-Account (2):
The total amount of the sales book is posted to the right hand side of the Sales account which is a general ledger account (nominal accounts). The key observation here is the information of the sales book has been posted to two sides left and right. And the total amounts of each side are the same, $500.
11. Posting Rule:
For reporting purpose, we need to close all the accounts, and list up all the outstanding balances periodically. This process is called “Trial balance“. Since the same amount is posted to both left and right side, the total of the debit balances and the total amount of the credit balances are always equal in the double bookkeeping system. This checking can be done with an accounting entry by transferring out all the balances to one account, called “control account”. The balance of this control account should be always zero balance, otherwise posting error. The key observation here is, recording of transactions, tracking of customer payment, and checking the posting accuracy are all done in the same format, i.e. debit and credit. This is the greatness of the double bookkeeping system.
12. Five Accounts (Cycle):
The next few slides are to answer which account and which side. This is determined by the financial statements.
As explained, debit and credit are just left and right. Therefore we need a context to determine which side. The context given is, first, company needs to raise money by borrowing money (liability) or using own money (Equity). Second, spend the money for whatever necessary to maintain a business (Asset). Finally, generate profit by using assets and the profit goes back to equity. The key observation here is, only Asset can have tangible accounts, such as lands and cash. The rest of the four are all conceptual.
13. Which Account (1):
The vertical line, in and out This distinction is linked with cash flow, either associated with in-coming cash flow or associated with out-going cash flow, with an exception of cash itself. The horizontal line, stock and flow are related to each financial period. If we need to retain for the next financial period, that is stock. If not, then flow. Again stock will be retained within the company, flow is not.
14. Which Account (2):
The outputs of the double bookkeeping system are BS and PL. BS is the list of outstanding balance of stock accounts. PL is the list of outstanding balance of flow accounts, and calculating profit. The distinction between B/S and P/L are sometimes arbitrary. An investment company led by ex-chairman of NASDAQ, Bernad Madoff, was collecting money from investors which are supposed to be stock, but distributed as profit to investors.
15. Which Account (3):
Here is the example of account names.
16. Profit Calculation:
The next few slides are to understand profit in detail. Business entities before the industrial revolution are more like a project basis. Once voyage or journey is over, liquidate everything, and the leftover is the profit. On the other hand, the modern business entities do not have the specific end date. Therefore profit has to be allocated across several financial periods. In short, PL accounts have introduced to allocate profit across periods.
17 Accounting Equations (1):
What we have discussed can be summarized into two equations. First, Balance Sheet Accounts, “Asset – Liability = Equity“. In this equation, increase in Asset automatically follows increase in either Equity or Liability to balance, indicating the double bookkeeping system. Equity is owner’s share after returning liabilities.
18. Accounting Equations (2):
Second, Profit / Loss statement, “Income – Expense = Profit”. When we post to PL accounts, we are touching profit.
19. Accounting Equations (3):
Profit is added from the profit and loss statement to the balance sheet every financial year end. In this example, the profit $100 is added, so that Equity is increased by $100, assuming no dividends. The key observation here is, BS and PL are linked via profit.
21. Posting for Allocation (1):
In profit distribution, there are always trade-offs among stakeholders. Say, tax authorities / short term investors would like to recognize profit (i.e. distribution) as soon as possible. Long term investors / debt holder would like to delay the recognition of the profit.
Profit can be manipulated either by deferral or accrual. “deferral “means, cash flow already happened but retained in B/L first , and posted to P/L accounts later. “Accrual” means cash flow has not taken place yet, but posted to P/L first before cash flow.
22. Posting for Allocation (2):
Once cash flow is either deferred or accrued, profit is impacted. And this information is kept in stock accounts i.e. B/S. This slide explains which accounts for which. Take depreciation as an example. A bakery shop purchased an oven for coming 10 years at the price of $100. If we post this $100 as expense in one shot, the short term investors will not have profit. For the sake of fair profit distribution, we post $10 for each year over the 10 years to expense account. In this example, cash outflow already happened. This is the case (A). Next, a bookshop received 2 years subscription fee $240 in advance. So we post $10 for each month over the two years. In this example, cash inflow already happened, but profit was deferred, so case (B). The importance thing here is, the adjustment of profit is accepted for certain justices, such as fair distribution of profits so on.
23. Posting for disclosure:
On top of the justice, fair distribution, there is new trend of a justice, so called “Disclosure”. This is because financial markets are so predominant nowadays. Profit can be up and down based on stock price, without any cash flows. The key understanding here is, profit can change even without cash flow. And this is the reason why cash flow statement has been introduced.
1 Opening : Bankingbusiness is one of the oldest, traced back to the 3rd century. The famous bank Medici bank was established at the14th century in Italy. This historical fact teaches us two things. First, banking business is simple, simple enough to be established in the medieval time. Second, banking business is lucrative, lucrative enough to bring a politician power, even nowadays. The question here is why it is so lucrative? And why banks are often protected by tax payer’s money? This presentation aims to answer these questions through understanding the fundamentals of Banking.
2 Agenda: This presentation consists of two parts, Money Supply and asset liability management (ALM). Re. Money Supply, it is all about understanding where dose Money come from. Re. ALM, there are a set of techniques to improve banks’ balance sheet and achieve sustainability of bank business, normally operated by treasury department.
3 Money Creation (Seigniorage): A customer deposits $100 in a bank, and the bank lends out $100 to a third-party. The actual money $100 is no more left in the bank. However, the customer can use the deposited money for settlement as long as the transaction takes place as an account transfer within the same bank. Therefore, to the customer perspective, the money $100 is still available in the bank, as long as it is in the form of account transfer.
The key observation here is, money has been doubled by the bank. The money $100 deposited by the customer has increased to $200 by the bank’s lending activity. This process called “Money Creation” or “Credit Expansion”, and the right to create money is called ‘Seigniorage’.
4 Money Creation (Multiple Effects): The $100 of loan will become the deposit of $100 in another bank eventually, unless the money is withdrawn to coins and note. And again, the same process can take place to increase the $100 to be $200 by the second bank’s lending activity. And the second bank’s lending can be deposited back to the first bank, creating a loop structure. All we need is just two banks to inflate money supply, by circulating money between the two banks. The key point here is, money is linking one another and sourcing from the same money.
5 Money Creation (Minimum Reserve requirement): With the discussion so far, theoretically, single dollar could be multiplied to the infinite amount of money because of the loop structure. This is not the case in real world, because central bank sets up minimum reserve requirement called deposit reserve requirement ratio (RRR) for the total amount of deposit, in order to control Money Supply. As the slide shows, money available for lending keeps shrinking, so that the looping of money cannot continue forever.
6 High Powered Money: As we have observed, money supply is expanded by banks’ lending activity. We have not discussed the starting point which will be a base of the expansion. To expand, we need a base. This base portion is called monetary base, supplied by the central bank. This is also called as high-powered money orM0.
7 Money Supply: Based on the level of expansion and availability for settlement, the degree of liquidity, there is a classification of money supply. As discussed, the base money is called M0, supplied by central bank. M0 expanded is, called M1. M1 expanded by money market is M2, so on. This classification is different from country to country.
8 Singapore (as of Feb 2010): Here is money supply statistics I took from MAS webpage. The key observation here is, Monetary Authority of Singapore provides money only $21 billion, but net deposit amount (M3) is $380 billion, more than18 times bigger than M0.
9 Banking / Shadow Banking: The story of banking accounts for only half portion of Money Supply. The other half is shadow banking, such as investment banking, hedge fund. One example of shadow banking is, say a bank has $100 first and buy $100 of a security. Then lend out the security to obtain $100 again. Then buy $100 of a security so on. As a result, this bank spent $200, based on the original $100. This is called leverage. Also you can do the same. Buying a property and put it as collateral to raise money and buy another property again. In both banking and shadow banking, the principle is the same, stretching out credit to create Money.
10 When a Bank goes into Bankrupt?: Please look at the number. 4000. This is number of commercial banks’ failures in 1933 U.S. alone. Last year, 140 banks failed. This number is excluding the number of banks saved by mergers and acquisition. Yes, banks do fail. To understand the necessity of ALM, we need to understand when a bank goes into bankrupt. First, cash flow problem. This is applicable to all companies, even to individuals. When a company cannot fulfill payment obligation, the company’s asset is seized and liquidated.
Second, capital adequacy requirement, this is specific to banks. This a preventive measure to avoid banks’ bankruptcy. Banks are taking a vital role of money supply. Once a bank is gone, it has a huge impact on economy. In addition, all money is connected via lending activities among banks. One bank’s failure can trigger off a chained effect, affecting other banks as well, called systemic risk or domino effect. This is reason why banks are regulated by authorities.
11 Balance Sheet: When we start a company business, we need money. One way to raise money is to invest our money called equity. The other way is to borrow money, called debt. Equity has no maturity. The company does not need to return equity money. Debt has a maturity and the amount the company has to return is fixed. That is why it is called fixed income as well.
Equity and debt, both are money, but we have to make sure, equity is used for a long term asset. Take a bakery business. We bought an oven with debt money, say the maturity is one month later. Obviously, we have to return the money in one month time, but selling the oven means closing our bakery business, no way to sell it within one month time. So that we should use equity for the oven, and use debt to buy raw materials such as wheat, sugars. Wheat and sugars can turn into bread within one day, and can be sold in the same day. We can have money back to repay debt.
12 Asset Liability Management: The same principle applies to the bank for the sake of sustainability. And there are some specific techniques applied to bank’s balance sheet, called asset liability management. The items we cover here is only “passive” techniques, primarily monitoring on market risk, interest risk. “Active” means being active to maximize profit and minimize cost. This could be a big topic such as trading strategy so on, so we will not cover this in this presentation.
13 Maturity Ladder: Constructing maturity ladder, a bank has to summaries cash inflow and cash outflow by dates, starting from the next day, based on different scenarios of interest rates change. Since we are creating different scenario to observe cash flow impact of the interest change, this may be called a simulation. Once mismatch between cash inflow and cash outflow is identified in the simulation, bank should take an action to change their balance sheet in advance as preventive measure. However, generally speaking, it is difficult. First, short term rate, such as overnight rate, is lower compared to long term rate. So banks are often tempted to borrow in a short term and invest in a long term in order to earn a profit. This is one of the cause, triggered the 1997 Asian financial crisis. Second, some banks business model is limited by a regulation. Say, S&L (Saving and Loan Association) in U.S. S&L’s business model is primarily focused on term deposit and mortgage loan. Since term deposit tenure is shorter than the period of mortgage loan, and the deposit rate was set to be very low by a regulation so called regulation Q, when interest goes up, money flies away from deposit upon maturity, although there are still outstanding mortgage lending. Again, this caused S&L crisis
14 Basis Value Point: This is price elasticity of fixed income against interest change. Bond price goes down, when interest goes up. Take an example, say, there is exiting government bond, matured in one year. The price is $100 and the coupon rate is 5%. That means it gives $105 in one year. At the same time, the government issued a new bond, again matured in one year, the price is $100 but the coupon rate is 10% this time. So it gives $110 in one year. When you want to sell the exiting bond, which is the coupon rate 5%, you have to price down to $95 to realize 10% interest with $105 upon maturity, otherwise who buys the 5% coupon bond?
Price goes down further when year to maturity is longer, say two years. In this case, total cash inflow of 5% is $110 and $120 for 10%. In order to sell the 5% coupon bond, we have to price down to $90 to realize the same profit. In summary, price is more sensitive when the year to maturity is longer, because the interest portions which we have to cover up by pricing down is getting bigger. This is why bond price sensitivity is also called “duration”.
15 Value At Risk: This is a portfolio value simulation based on historical data. Using certain period of historical market data, calculate the exiting portfolio value, and see how the value fluctuates. When VaR indicates portfolio value can drop significantly, we should change the portfolio to be more stable, or shorten the holding period of the portfolio. The problems of VaR are 1) it requires lots of computation. Once portfolio changes, we need to recalculate again. 2) Market data. The choice of market data could be arbitrary. If too old, underlying market condition could be different.
16 ALM Continued: Again, ALM is to achieve sustainability of banks. If we lend out to terrorist group, it will cause reputation damage. If lawsuit, we need to raise contingency liability. With credit risk, we need to raise provision. So on. Some banks have an ALM committee to review Asset and liability regularly from top management point of views.
1 Opening : The Principle of Settlement Hello everyone, my name is Yoshi. Today, I would like to present on the topic “The Principle of Settlement” .
Say, 30 years ago, during the good old days, every process is manual, tangible, and visible in banking. At the end of each day, bank officers are getting together physically at a clearing house where we can find small bank counters, calculating net amounts, issuing bank checks each other, and settle at MAS account. It was very easy to share the same picture. But, how can we share the same picture when things become invisible, hiding behind a computer screen? One good example. Some might think swift is a settlement system. This is not correct. Swift is more like a “telephone”, even used by shipping companies through banks. This is an analogy, say, I have an offshore account, and use my mobile only for telephone banking to send money from offshore to a local bank. Can we say mobile is a settlement system? The answer is No.
2 Agenda: There are three items as shown on the slide. The most important item is the second one. “understand the trade off”. Once we understand the trade off, we can design a settlement scheme based on boundary conditions given to us. And we can assess a settlement system in a country. For example, check. If postal cost is very expensive and not reliable, is it check efficient? No, right? It becomes very expensive with check settlement. Therefore, actually there is always prerequisite for us to design a settlement system in a country.
3 What is Settlement: Settlement is a process to resolve the relationship of “I Owe You”, “You Owe Me” with finality. With finality, there is no unwind of transactions. Once finality is granted, banks are never to be obliged to unwind transactions. This is very important for financial institutions, as unwinding transactions can be very complicated process, and can be extremely costly to unwind a very old transaction. Finality is the one of the most important thing to be maintained in a financial center. If there is no credibility to the Finality in the financial center, banks will go away.
4 How to Settle (1)? : First, payment. Payment consists of the two, cash payment and non-cash payment. And non – cash payment consists of debit transfer and credit transfer. Cash payment is ideal in a way finality is granted on the spot. That means, if you received 10 dollars for a change one day, you cannot go back and say “Hey, you should have given me 100 dollars, instead of 10 dollars for the change”. This is because no way you can prove the shop keeper gave you a wrong amount. And there is no record tracking with cash, unlike account transfer, how much the shop keeper paid out for the particular transaction.
What I do not cover with this presentation is, DVP, PVP. Delivery versus payment and payment versus payment. Usually, transactions are two ways. When you pay in exchange for something. With PVP, underlying transaction is Forex. We have to receive foreign currency equivalent in exchange for local currency equivalent simultaneously. This requirement makes settlement process more complex, such as pre-matching so on. However, as long as our scope is loan and deposit business today, transaction is one way. So I do not touch DVP, PVP.
The next is Delivery. When a company purchases a company, which called acquisition, the company can settle by delivering shares.
The last one, others. There are many ways to fulfill our financial obligation associated with a transaction. In the end, with OTC, over the counter transaction, it is up to a counterparty whether he or she accepts. Usually, when we purchase a good, we pay cash. But if you are very famous, you might be able to buy a small thing for your autograph. If you were Michael Jackson, you might be able to purchase, even a car for your autograph. I heard a famous calligrapher settled a bill at a restaurant by his calligraphy, just writing “life is great” or something on the spot. This also depends on a society. Some societies might allow you to escape from your financial obligation when you become a monk. And sorry to say this, committing suicide is also common way, so please do not try.
The important thing to understand here is, payment is not equal to settlement, but a small portion of it. 5 How to Settle (2): There are two types in non cash payment, debit transfer and credit transfer. The former can be check payment, the latter can be giro payment. The difference is the direction of the instruction flow against payment. If payees’ bank are receiving payment as well as instruction, it is credit transfer. If payees’ bank are receiving payment and sending instruction, it is debit transfer. With debit transfer, a payee’s bank is sending debit instruction to payer’s bank. So that there is possibility the debit instruction fails due to balance shortage. With credit transfer, payer’s bank debits an account in it own bank first, then send a credit instruction to payee’s bank. Since debit instruction may fail, that is why we do not use it for real time, or critical settlement systems.
6 Which is the best ?: Do you have any idea which is the best? The reason why the net-real time box was stroke out is, to net, payment instruction has to be deferred and accumulated. There is no way to be both “Net” and “Real time”.
7 Risk Analysis: The answer is…it depends. This is the place where trade-off comes in. If you think banks’ operations is very bad. In case there are too many instructions, operations tend to fail more, then netting is required. If most of the settlement instruction is time critical, real time is good. Also it depends who you are. If you are a settlement officer, your concern is the volume of the instructions to process. If you are a regulatory authority, your primary concern is likely systemic risk.
When we design a operational process, we need to think about five risks. Here is a list of the common risks. Liquidity risk, a bank to fail preparing money for payment. Operational risk, such as crediting/debiting a wrong account by mistake. Systemic risk, one failure triggers another automatically, like domino effect. Credit risk, the risk of our counter party going into bankruptcy. I did not list up here, since we do not need to think about the underlying transaction here, yet, market risk is also an important component.
This is a qualitative analysis, not quantitative, so we can always argue, and it is essential to go through plausible cases, rather than abstract concept.
8 Analysis continued: Cost is also important factor to design a settlement scheme. If economy is very small, the best scheme might be “cash settlement” for all. If you create a real time gross settlement system, this is a relatively big IT project. It requires a certain level of IT skill set.
9 Clearing house: Netting is done by a clearing house. Clearing is a process to calculate net position based on deferred or accumulated instructions.
There are many types of netting, but let us focus on two, bilateral netting and multilateral netting . Bilateral netting is calculating the netted amount grouped by counterparts. For instance, if bank A receives 30 and 10 from bank B, pay out 51 to bank B, the net position of bank A is minus 11, that is pay out 11 to bank B. Bank A has aggregated the three instructions down to one for bank B.
Multilateral netting is, to see the clearing house as a counterparty, calculating one netted position based on all the instructions. All payments are fused into one, so that all instructions will be affected, when one instruction has got a problem such as paying out to sanctioned client. This is so called “systemic risk” as one failure impacts many. So actually dangerous. One way to avoid this, do not net, especially when amount is big.
10 Systemic risk: Systemic risk will be created when a bank enters into another transaction without getting finality on the previous transaction. Once the previous transaction is unwind, the bank will have an exposure suddenly. To avoid this, bank should not enter into a transaction without getting finality with previous transaction. Also this becomes a big issue when we talk about a security settlement, If the security which Bank B needs to deliver to Bank C is very scarce, and we fail to obtain it from Bank A, automatically Bank B fails to deliver it to C.
The other case is, netting. Again once we net, transactions are fused into one. And if one underlying transaction fails, all fail automatically.
11 Domestic /International Settlement Do you have any idea which is Nostro/Vostro account? This is a trick question. The answer is both are in Bank X. When Bank B opens an account in Bank X as a part of corresponding bank agreement, only Bank B has a right to debit and credit the account in Bank X. Bank B is the owner, and call it Nostro account. From Bank X side, Bank X is providing administrative services through the account, yet has no control over, so call it Vostro Account.
Domestic settlement. When bank A sends money to bank B. It has to go through a central bank. This is where finality comes in, as only central bank can grant finality. Also, instruction might be already netted at this stage, so if it fails, all the underlying transactions fail. To make the transactions as smooth as possible, to prevent system risk, the central bank usually gives overdraft if necessary. Also all the banks are connected to the central bank, in Singapore via the interface MEPS, that is the reason why Swift does not come in this picture.
International settlement. The key point of understanding international settlement is, regardless of security or money settlement, securities and money do not go beyond borders. That is why we have to contract a corresponding bank agreement. And instructions are not necessary to be Swift. If the corresponding bank is the same bank but different branches, why we send instructions through Swift private network. We can send instructions through bank’s private network. However, this is very much invisible part, whether using bank’s private network or swift private network. Also theoretically we may use a telephone as I do for offshore banking, if both parties agree. But obviously this is lack of control.
There are only two types of money in this world. One is “my money” and the other is “your money”. In corporate finance, the former is called “equity” and the latter is called “debt”.
How efficient is my money utilized? Namely how much return per one unit of “my money”? The formula is given as return divided by “my money” (equity), so called Return of Equity (ROE).
There are only two ways to improve ROE, to increase the return or to decrease the equity. The latter can be achieved by utilizing “your money” i.e. borrowing your money, so that the share of my money per return will decrease. Then I can claim, “I am using my money efficiently”.
Quick question. I lend you 100 dollars and you lend me back 100 dollars. Is it my money or your money?
Technically, it’s your money. The 100 dollars are on my hands now but obliged to pay you back in future, as it belongs to you. I am just “borrowing”.
So… now I know it is your money… (My personality suddenly changes). Who cares about your money! I am the risk taker! Let us put your money into a risk asset such as sub-prime. (10 sec….). Oops, no money left to return “your money”, but can you pay me back “my money”?
In MBA, the place we can learn about the current “Capitalism”, being taught the virtue of borrowing money, and draw the clear line between your money (debt) and my money (equity), lacking a holistic view.
Yes, money must be used efficiently, and CAREFULLY regardless of my money, your money.
Learning statistics is tough. How come we can be sure about population distribution by sample mean distribution? The answer is "not really", but statistics does provide us an unique measurement for unknown based on assumptions.
Sample mean distribution is normal distribution, which can be defined only by two variables: Mean and variance, and the mean of the distribution will be same as the constant value, population mean, provided the sample size is big enough. This is guaranteed by averaging out.
Once we know the sample mean distribution is normal, Z-value which is relative deviation from the population mean using SE (stand error, population variance divided by the number of sample) as the unit of the yardstick of measurement will explain the percentage of the probability, by what chance, the sample mean can fall within the reach of the Z-value yardstick. If the Z-value is +/-1.96, the chances are 95%. This could be fair, as any normal distributions are defined by mean and variance. Here come my questions:
Q1. How does the sample mean distribution guarantee the shape of the normal distribution by averaging out? Q2. How come normal distribution can be defined only by two variables? Q3. Where does the number 1.96 associated to 95% come from? Q4. How can we state, “the sample is big enough” universally without knowing the real shape of the population distribution?
T-value (student’s T) is used when we do not know the population variance and replace it with a sample variance to construct the yardstick. For 95% chance, T-value can vary along with the degree of freedom (d.f.), which is the amount of information available based on sample numbers. For d.f. 120, T-value is 1.98, slightly bigger than the Z-value as we use less trustful yardstick of sample variance, rather than population variance. Again, here come my questions:
Q5. Where does the number 1.98 come from? Q6. By what, it makes THE difference of THE NUMBER 0.02 for d.f.120 Q7. How come the divisor of sample variance is always “n–1“ to adjust the measure of spread? And how can we be assured –1 is always sufficient for any sample numbers.
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