Sometimes we take the wrong things for granted. How your car actually works – God, Martha, it takes a HUGE website to explain it! Thankfully you can ignore all that if you have a trustworthy mechanic and know where to put the gas in. Air conditioning? Smoke and mirrors as far as I’m concerned; how can compressing a gas result in cold air for my house?
Banking – it’s simple right? You put your money in, they loan some out and collect more back – sounds perfectly safe. Not quite so fast there Junior, banking has risks too. In Finance 101, they present banks as the safety nets, then in Finance 2 you learn the truth: ain’t nothin’ safe. Banks face two major risks, insolvency and illiquidity. Illiquidity is easy to understand. You need enough cash flowing in to pay out current obligations every day/week/month. Simple.
Insolvency, on the other hand, is a bit more murky. Aren’t loans guaranteed by collateral? Wouldn’t the bank just drive by and pick up Uncle Teddy’s Cadillac if he didn’t make his payments? There’s a lot more to it than that, especially in these days of fiat money and ever-changing markets. Today’s featured read is a short paper from the DeGussa group explaining banking risks in a very clear, straightforward manner. Especially as it relates to European banks and the huge issue they’re facing.
I really wish this paper was out back when I was in school, would have saved a weekend of hard slogging through some awful finance book, written by someone who clearly liked to hear themselves think.