One of the most important aspects of the current crisis is the issue of credibility of the institutions that were considered above reproach, and totally reliable. As it transpired later, many of these institutions were found sorely wanting in competence, as well as integrity.

The optimism about the current situation is mainly on account of the fact that job losses that were supposedly estimated to be in the region of approximately 325,000, turned out to be only around 247,000. It is not clear if the estimates were accurate or there is a real improvement in the ground level situation.

Some of the areas where job losses occurred in good numbers are the financial services, the construction sector, and the hospitality industry, while the auto industry added several thousand jobs in the otherwise cloudy scenario.

It remains to be seen, however, as to when and at what rate consumer spending would improve. That would be a key indicator of consumer confidence, as well as availability of disposable incomes. The economic recovery chain does not appear to be consistently strong throughout. There are weak points that could easily pull the positives back to square one.

If the American economy is really on the mend, it is definitely not at a pace that many fondly look forward to.

The current economic crisis has thrown up challenges that are difficult to beat, with conventional strategies.   New ideas, and new innovations need to be promoted to remain in business, and make profits.   Apart from new ideas, Banks should also revisit some old ideas that they may have ignored in their pursuit of zany and sophisticated sounding businesses like derivatives etc.   One such idea is the concept of “cross selling”.

Cross Selling:  Cross selling refers to the activity of garnering more business from an existing customer, in addition to the one he is availing presently.   Often, we come across a Bank customer, who has a deposit account with one Bank, and a loan facility with another.   Or a customer who has a personal loan with one Bank, and a Credit Card of another Bank.  

The idea behing cross selling is to target such customers, to structure a range of products, and at such prices,  that it becomes attractive and viable for the customer, to avail of al his banking needs at one place.  

Let us take the typical case of a family of four, comprising of husband, wife and two children.   Let us assume the husband is a Executive in a Printing Firm, the wife is a home maker, and the two children go to school.

In a case like this, the family may need one or more of the following banking services:

1. Savings accounts for all the family members.
2. Recurring deposits in the names of the children, to inculcate the saving habit, apart from such accounts for the parents also.
3. Fixed deposits for lumpsum amounts, from time to time, in the names of the family members.
4. A home loan facility for purchase or construction of a family home.
5. A consumer loan for acquisition of consumer durables, and furniture, etc, for the home.
6. A car loan for the family car.
7. Personal loans for the parents to meet any exigencies.
8. Credit cards for the parents.
9. An Educational loan for the childrens’ education.
10. Travel loans for the family to go on holiday.
11. If the wife is interested in pursuing any home based business, then a suitable loan may be considered.

The above list of services that a Bank can offer to a typical family gives an idea of how many income streams can be created with an existing custome, with who the Banks is familiar, and conversant with his financial dealings, social status, and credit history.  

In the same way, the customer is also familiar with the Bank, and once he is satisfied with the services availed of by him, he would be prepared to shift all his business to a particular Bank.   This will result in building a strong relationship between the customer and the Bank, for mutual benefit.

                                                                                                    To be concluded.

While many of the human inventions fave fulfiled a genuine need, some inventions have served only their contrived needs, and yet  others have catered to the baser instincts of man, primarily, greed.

Into which of these above categories does the financial instrument called derivatives fit in?   Does it serve a genuine need or a contrived one, or only serves to pander to man’s greed?   In the light of the present Banking crisis, said to be triggered by the housing mortgage crisis, it would appear that derivatives fall in the last category, that is , to pander to man’s greed.

Be that as it may, it is worthwhile to study the subject of derivatives, if only to avoid such pitfalls in the future.

Definition:  A derivative is a kind of financial instrument that does not have a value of its own, but derives it from an underlying base.   This base may be an asset, or an index, or even a phenomenon.   In a way, a derivative resembles a parasite that feeds off its host.

Derivatives do not have an independent existence of their own.   They exist as offshoots of either assets like stocks, commodities, residential mortgages, etc.;  or indices relating to the stock market, consumer prices, exchange rates, etc;  or even phenomena like the weather conditions.   They derive their values and standing from the above assets etc, as listed above.

Purpose and Scope:  There are several purposes for which derivatives are put to use.   Sometimes it relates to genuine business transactions and the related risks, and sometimes to plain profit making.   Sometimes it is dictated by necessity, sometimes by inclination.   Some of the major purposes of derivatives are:

Risk Management:  The major purpose of having derivatives is to manage or counter risks faced in the business environment, especially that which cannot be dealt with conventionally.   It is also called Hedging.   Hedging occurs when the risk of the underlying asset is transferred through the medium of the derivative from one person to another.   A forward contract in a foreign exchange transaction like export and import is an example of hedging.  

Suppose an exporter of wheat based in Chicago exports a consignment of wheat to the United Kingdom, and expects the rate of the British Pound to decline against the U.S. Dollar, he may book a forward contract and sell his pounds at current rates against future delivery of wheat to the U.K.

Speculation:  Another purpose for which derivatives are used may be to book extra profits, or profits out of the ordinary, by taking advantage of the favorable movement of the value of the underlying asset.   Here the purpose of using derivatives is not hedging, or countering risk, but to scoop up additional profits.   This activity is called speculation.

Arbitrage:  Yet another purpose of derivatives is called as arbitrage, that is taking advantage of a lower current market value vis a vis future value of an asset.

Whereas the use of derivatives to counter business risks related to genuine busines transactions, may serve the purpose of utilizing derivatives, the same cannot be said of speculative activities, that have cause mayhem in the markets, more than once, in different parts of the world, notably the United States.

Types of Derivatives:  Like there are two types of medicines, viz, over the counter, and prescription ones, so also there are basically two types of derivatives, the Over-The-Counter derivatives(OTD), and the Exchange-Traded-Derivatives(ETD).

Based on these two classes of derivatives, there are three kinds of them like Futures, Options, and Swaps, that are briefly discussed below.

Futures and Forwards:  These are financial contracts with a committment to buy or sell an asset within a certain future date at today’s price.  That is future buy/sell at current rates.   While a forward contract is an examle of an OTC derivative, a futures contract is an example of an ETD.

Options:  These are contracts that entitle their owner to either buy or sell an asset without imposing an obligation to do so (buy or sell).   The option to buy relates to the call option and that to sell relates to the put option.  The price of the transaction is fixed at the time of making the contract, and is referred to as the strike price.   Another feature of this contract is the maturity date.   Here again, there are two options- the European option, and the American option.   Uner the European option, the owner may specifry maturity date only as date of Sale;  whereas in the American option, Sale is allowed to take place on any date upto the maturiey date.

Swaps:  Under this type of contract, the underlying values of currencies, bonds, commodities, stocks etc., are exchanged on or before a specified future date.

As can be seen from the foregoing, derivatives may be used to either hedge one’s risk, or to make super profits, or just settle for arbitrage.   As these instruments do not have a vlaue of their own, they are vulnerable to any kind of shift or change in the value of the underlying.   As such they may not be very reliable in countering risks unless the issues affecting the values of the underlying are properly understood and provided for.

It is pertinent to note here, how the derivatives have played havoc in the U.S. housing mortgage sector, that is the major reason for the current American Banking Crisis.   Based as they are, more on mathematical calculations than solid assets, or money’s worth, the derivatives, as financial instruments, were always a weak and vulnerable proposition for risk management, and when the first strong winds hit the derivatives market, they started spinning out of control, taking the whole banking industry with them.

From the way the derivatives market crashed, it has given rise to suspicions as to the competence of the ‘experts’ and ’specialists’ who spun out these instruments seemingly through a ‘divine’ combination of their super brains and computers.

As for the regulators, perhaps, they did not want to look like fools before the derivative whizkids, by posing mundane and ’stupid’ questions about what exactly these instruments were composed of, how they were valued, and indeed the necessity and viability of these financial instruments as a tool of risk management.   In the end, the regulators have ended up looking like bigger fools for not doing their mundane and ’stupid’ jobs.

This service provided by Banks, namely, financing, or more commonly called lending, is fraught with several inherent risks.   Loan defaults may occur for more than one reason, including reasons beyond the control of the borrowers, like for example, in case of floods or a Tsunami, that may wipe out the assets of the borrower, apart from rendering him incapable of restarting his  business immediately.   The most serious risk to Banks in the lending process is the risk of non payment of the loan by the borower.   Imagine a situation where none of the borrowers of  Banks repay the loans availed of by them!   This could lead to a collapse of the  Banking industry!

The current spate of Bank failures in America and elsewhere, is, in good part, on account of borrower defaults.   Whereas, in an ideal situation, every borrower repays the loan availed by him, from the Bank, in real life, this does not happen.   Many a time, borrowers, both individuals and institutions, fail to keep up their repayment committments, affecting the well being of the lending Bank.   Sometimes, there are even genuine reasons why borrowers become defaulters.

This being the case, Banks invariably, have in place, norms and procedures that they follow before parting with money to a borrower.   Banks examine and evaluate credit proposals, as to their viability and feasibility, both technically and financially, before taking a decision to grant a loan.   Each loan is appraised individually to ascertain the soundness of the proposal and only then a decision to grant a loan is taken.   Among the various precautions observed by the Banks to safeguard their interests in the lending process, is the obtention of security for the loan extended by them.

Definition of Security:  Security, in relation to a loan extended by a Bank to a borrower, means, an asset, of any kind or description, having certain qualities, among them, monetary value, that can be possessed by the Bank, in the event of default, and applied toward repayment of the loan.

Having extended the loan to the borrower, Bank would naturally like to ensure that the loan is repaid with the interest thereon.   That is, Bank would want to secure the loan.   This is done by way of creating a charge against the asset financed by the Bank.   The type of charge created depends on the nature of loan, and the security.

Basically, there are two types of securities availabe to Banks to secure a loan.    They are Primary security and Collateral security.

Primary Security refers to the asset directly created out of Bank finance.   For example, where a Bank finances the purchase of a home, the home is the primary security.   In the same way, a car purchased with the help of a Bank loan, is the primary security for that loan.   Bank creates a charge against this primary security, to secure its loan.   This charge give the Bank the legal authority to dispose off the asset, and apply the proceeds therefrom, to the loan amount in default.

Collateral Security refers to certain additional security obtained by the Bank to secure the loan, in addition to the primary security.   For example, say, a Bank has financed the purchase of machinery by a Pharmaceutical manufacturing company.   This machinery would be the primary security for this loan.   In addition, the Bank may obtrain collateral security in the form of the factory building and land owned by the company, as an additional security.   This will secure the Bank further and safeguard its interests in the event of the primary security not having sufficient value to liquidate the loan.   Many a time, it so happens, that on account of adverse market conditions, the value of the primary security gets eroded, exposing the Bank to a higher level of risk han it had originally bargained for.

In addition to the above discussed securities, there is also the scope of securing the loan with the help of personal security of the borrower.   Obtaining personal security of the borrower enables the  Bank to proceed against the borrower and his personal estate, in order to recover the loan.

Qualities of a Security:  In order that a security may provide a real means of liquidation of a loan in part or in full, the concerned asset must have the following important qualities, among others:

1.  Valuable Security:  A security obtained as a cover against default, of the borrower,  in repayment of the loan, must have some monetary value that can be realised and adjusted toward the loan.   Intrinsic value alone would not be helpful to the Bank in mitigating the problem arising out of a default.

2.  Marketable Security:  Even though a security may have a monetary value, it may not be  possible to encash the value as and when needed by the Bank, because it may not be easily marketable.   That is, it may not be easy or even impossible to dispose off the security and realise its proceeds, for various reasons.  

For instance, the asset obtained as a security for a loan, may not be in demand, at the time it is required to be encashed or realized and credited to the loan amount in default.

3.  Stable Security:  Stability of security here means the stability of the value of security.   Certain securities have widely fluctuating values, depending on market and other conditions.   As a rule, Banks prefer securities that are not prone to market gyrations, and offer a reasonable chance to the Bank to have it adjusted to repay a good part of the loan in default,  if not the  entire loan.

4.  Transferable Security:  The security offered by the borrower to secure the loan, must have the quality of transferability.   That is , the ownership, or the interest in the security, must be capable of being transferred to the lender, without too much effort and expemses.

As can be seen from the above, securing the loan extended by the Bank is of vital importance and also necessity to the Bank, as otherwise, it may jeopardise the interests, or even the survival of the Bank.   That apart, securing a loan with an asset of the borrower increases the stake of the borrower, who would have more reasons to make his venture a success by doing his best.

This home truth has been forcefully brought forth in the current economic crisis, in which many Banks have realized their folly in not properly securing their loans.