IT has revolutionised the entire world. Banking sector has also been revolutionised by this IT revolution. Gone are the days when you had to stand in the queue in a bank to get your cheques cleared, or stand in a queue to pay your Electricity bills and fight with a Bill collecting clerk at BSNL office. Internet has revolutionised the way users use to do their daily businesses. It had made it easy to shop and avail services like internet banking from anywhere, anytime without physical presence.
“Banking the unbanked” is the topic that I first heard during Davos 2007 media reports. There are hundreds of reasons for large part of population in many countries – developed, developing and underdeveloped – to stay outside the realms of banking. The reasons vary from logistics to cost of transactions, lack of financial literacy and products that meet the requirements of the unbanked people. The major reasons for the lack of credit available in the less developed part of the world are pretty self-explanatory. Most of the unbanked population is poor, they represent a higher risk and lower return on investment for banks and financial institutions, and as a result, they’re reluctant to get involved in these regions.
- Yield spread is a way of comparing any two financial products.
- Yield spread is the difference between profit you can make in two different types of investment.
Why do we need to calculate Yield spread?
Before coming to the purpose of calculating yield spread, lets go in a different direction.
When you buy a Government bond, you can be certain that you’ll be paid in full, after the maturity and they’ll not run away. So in this case risk is very low, hence they sell like hot-cakes. That’s why they’re called “Gilt edged securities“
When risk is low, it doesn’t carry much profit.
But some junk company is issuing bonds, no one has ever heard of them.
So their bonds carry high-risk of default, hence people won’t be interested in buying it as such.So,The company will offer extra-high return (profit) on their bonds, to attract people.
In short : Higher return is offered when Risk is HIGH.
Scene 1: Year 2010
For every 100 rs. Invested in Government bond, you get Rs.5 return after 1 year.
For every 100 Rs. Invested in the junk bond, you’re offered Rs.13 return after 1 year.
So yield spread = (13% minus 5%) = 8%
Scene 2: Year 2011
Government bond’s return remains the same but now that junk bond company is offering you 20% return.
So Yield spread = (20% minus 5%)=15%
In one year, the yield spread has widened from 8% to 15%.
As we saw above, Higher the risk, higher return is offered.
So, market is forecasting a greater risk of default which implies a slowing economy.
A narrowing of spreads (between bonds of different risk ratings) implies that the market is factoring in less risk (due to an expanding economy).
# As described by Mrunal
First lets see what exactly is CRR and SLR:-
CRR – Cash Reserve Ratio:- You’re a banker, you’ve to keep deposit that much ca$h in RBI.
SLR - Statutory Liquidity Ratio:- You’ve to keep that much gold/ca$h/bonds in your bank.
Lets assume you’re a banker, have 100 Rs. cr.
Out of that you were required to keep aside 1 cr. worth cash, gold etc. in SLR+CRR in Jan’11 as per RBI order.
So you’ve 99 cr. to give as loan and earn interest out of it.
But in Feb’11, RBI increases both ratios, so you’ve to keep aside 15 cr. in SLR+CRR.
So you only have 85 cr. to give as loan and earn interest out of it. Obviously you’ll charge more interest, when giving loans, to maintain same amount of profit.
How does this affect economy?
- Well Lower SLR+CRR, means bank can give more money as loan = lower interest rates = cheap loan = more people take loan to start business or building house or buying car = boost in economy
- HOWEVER, can also lead to inflation, if people have more cash in their hands than the items available for purchase in the market.
- Higher SLR+CRR = bank can give less money as loan = HIGHER interest rate = it becomes expensive to start a new factory, buy a new house / car/bike. This can curb inflation but may also lead to slowdown in economy,because people wait for the interest rates to go down, before taking loans.
In simplest form Its buying insurance against a default.
I’m a banker, gave car-loans to dude, but I’m afraid he might not pay back the full money. So I’ll goto some other Bank X who sells Credit default Swaps (CDS).
I’ve to pay regular premium Bank X, but if someday that dudes default on his car-payment, Bank X will pay me the money.
RBI is currently drafting rules for starting a CDS market in India.
These CDS bonds, once issued, can be sold and bought like any other bond or security but only thing is that they are not regulated.
i.e. Bank X sells my CDS to Bank Y. So now Bank Y gets my premium but in case of default by that Dude, Bank Y is supposed to pay me.
# As described by Mrunal
- CDS going wild (forexlive.com)
- Lehman Brothers: a primer on Credit Default Swaps (creditwritedowns.com)
- The depressed market for Greek default recoveries (ftalphaville.ft.com)
- Greek CDS spreads at record; Italy, Spain stable (marketwatch.com)
- Those Greek credit default swaps? (forexlive.com)
- FSA Said to Review Credit-Default Swaps in Market Abuse Probe (businessweek.com)
What is Credit Crunch?
In simple words, when you can’t get loans easily, its credit crunch.
Definition: Reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from the banks.
Examples of credit crunch
1. In America, banks were giving housing loans to any swinging dude, without checking his credit-worthiness (like can he really pay back the loan or not?). This lead to mass-defaults after few years. Now bank managers are very cautious and before processing your loan application, they’ll check it 17 times! this is also a sort of credit crunch because you can’t get loans that easily, like you used to get, before the recession.
2. In 3G auction spectrum, telecom companies took 70,000 cr. from Indian Banks to bid in the auction. = lot of money flew out of the system. So for a time being, banks have less money to give as loans to other customers = Credit crunch. (although that didnot happen) but suppose Mukesh Ambani had called up a bank asking for 50000 cr. loan for acquiring a foreign company next morning, Bank manager might have said ‘Sir, sorry we don’t have no money!”
Implications of Credit Crunch
Credit crunch is not good for economy, because
- A businessman wants to start new factory, but cannot get loans easily = slowdown in economy.
- A couple wants to buy home, but can’t get home-loan easily = slowdown in real-estate sector.
- A college kids wants a new bike, but his dad can’t get loan easily = slowdown in automobile sector, but also good from climate-change angle. as people will be forced to use public transport system
If such credit crunch continues for a long time, it’ll lead to job-losses, factories shutting down and finally recession.
But sometimes credit crunch is a necessary evil, when there is too much liquidity (money) in the market.
Too much liquidity = too much money = easy to get loans = people have more money in their hands compared to the items available for purchase = hyper-inflation.
From the previous post about CRR & SLR, we can also say that an (Excessive) increase in CRR and SLR will lead to Credit crunch.
##As described by Mrunal