Just How Important Is Consumer Confidence in Global Financial Markets?

In 2008, Warren Buffet described confidence as being the oxygen to an economy. Buffett explained how confidence is key to the economy when explaining, “I don’t think I’ve ever seen people as fearful economically as they are right now.” Essentially confidence is a major factor within the economy, as if people are not confident in a financial system, they will not use it. We only need to look at the current situation in Cyprus to see how a lack of confidence can damage an economic system.

Essentially Cyprus is now in a situation whereby it either accepts the proposed bank levy on savings or leaves the Euro. Neither of these options are good for Cyprus as a nation, or its people, however due to the situation the nation has got itself into, it has no choice. However, as mentioned, the crisis in Cyprus is one of confidence. Firstly the nation’s banking system has been damaged. This is due to consumer losing trust in the system, which was inevitable once the government initially contemplated the possibility of taking away part of the country’s bank deposits. Restoring this trust and confidence will be a long and difficult process, however is the only way the economy can return to a fit state. Secondly, and perhaps more importantly, consumers trust in the Cypriot government and European Union has been damaged, which again is difficult to restore.

So having considered the loss of confidence within the Cypriot economy currently, we should consider why this is actually a bad thing. Essentially if consumers are not confident in their economy, they will not use it. This has been demonstrated by the reported queues at cash machines this week in Cyprus, with limits imposed on withdrawals. It will be interesting to see what happens once Cypriot banks unfreeze accounts, however an obvious prediction would be that the majority of people take their money out of their accounts. This would be a reasonably normal concept to see when consumers lose faith in the state of an economy, however with the added potential for a tax on savings, in this case it is even more likely. So why is this bad then? Well firstly if everyone wants to withdraw their funds, the bank will simply not have the cash to pay this out. This is because a bank works by taking cash from people in the short term and lending this out in the long term in the ‘maturity transformation’ sense, keeping only a small amount of cash to cover the day to day needs of people. Whilst in the short terms banks simply do not have the cash to pay people out, the bigger picture is that banks will have less money, meaning they have less ability to generate funds and therefore the economy will begin to stagnate and growth will be minimal.

The original question posed at the start of this blog was to examine just how important confidence is within an economy. Confidence is essential for an economy to run smoothly, a point highlighted by Warren Buffet. If people trust an economy and are confident within it, then they are likely to be happy to invest their money, allowing banks to use this to lend out, essentially increasing their profits but also increasing the money flow within an economy along with economic growth. However, when looking at the example of Cyprus, we can see just how catastrophic it can be if confidence is removed from an economy. Therefore in my opinion and probably in the general opinion of most people, confidence is one of the key factors to maintain within an economy in order to ensure economic stability.

Was the Financial Crisis Avoidable?

‘The global financial crisis’, ‘the credit crunch’ and ‘the recession’ are just a handful of titles describing the largest worldwide financial crisis since the Wall Street crash and Great Depression of the 1930’s. The financial crisis arguably began in August 2007 when BNP Paribas refused withdrawals from hedge funds due to “a complete evaporation of liquidity.” This was essentially the catalyst to the situation, however this blog will assess whether the crisis could have been avoided long before this date, or whether it really was an unavoidable ticking time boom waiting to happen.

Before we assess whether the financial crisis was avoidable, it would be a good starting point to discuss the actual causes of the crisis in the first place. In my opinion, it would be fair to say that there is no simple answer to this, with the crisis more than likely being a result of a number of factors and failures within the financial industry.  Barack Obama claimed that a ‘culture of irresponsibility’ was responsible for the crisis. This is probably true in most places with excessive borrowing due to factors such as a lack of corporate governance and dysfunctional incentive systems causing firms to collapse. As discussed through a number of my blogs, with greater risk, comes the potential for greater reward, however in the case of the financial crisis in 2007, firms took on too greater risk which did not pay off.

One of the key factors linked blamed for the crisis was the sub-prime lending business, whereby financial institutions offered mortgages to individuals with poor credit histories, packaged these as mortgaged backed securities in the form of collateralised debt obligations and sold them on globally to investors. As interest rates rose, homeowners could not afford the repayments and defaulted on their debt in large numbers, affecting bank’s liquidity and therefore ability to repay investors. The existence of an off balance sheet and almost unregulated ‘shadow banking system’ made up of investment banks and hedge funds, allowed institutions to leverage themselves so highly, that they were essentially loaning out money which they could not support through capital in the event of credit defaults. The lack of legislation and regulation in such shadow industry allowed firms to act upon their own accords. This combined with dysfunctional remuneration packages, in that employees were rewarded for short term success and therefore taking risks, encouraged employees to increase their firm’s leverage and therefore issue increased mortgages and loans.  Eventually the whole system failed, as financial institutions had too much debt and not enough capital to support this debt, which combined with vast credit defaults, lead to illiquidity of banks, resulting in a number of collapses and government bail outs to resolve the situation.

Essentially Barack Obama’s simple claim regarding a ‘culture of irresponsibility’ was correct, as responsibility on a number of levels arguably could have prevented the crisis. Firstly corporate governance needs to be applied internally by firms. The most widely used definition of corporate governance is "the system by which companies are directed and controlled" (Cadbury, 1992), therefore explaining how firms need to conduct themselves in the correct way to ensure their success. Clearly this was not the case as corporate governance surrounding leverage limits along with dysfunctional behaviour was not in place, leading to financial institutions making huge losses. Such corporate governance was highlighted to myself first hand whilst on placement at UBS in 2011, whereby rogue trader, Kweku Adoboli was allowed to incur losses of around $2 billion due to a lack of corporate governance controls in place and remuneration packages encouraging such risk raking. In the weeks after this event, corporate governance controls were noticeable tightened as all staff were made to complete rigorous training exercises and compliance's role became more apparent in the day to day running of the organisation. Another example of irresponsibility could be through the lack of legislation by governments. If governments had stronger legislation upon the shadow banking industry or minimum levels of capital firms had to hold for example, then firms would have been less likely to have been able to get into the situation they did. Such regulation has now been put into place, such as the recent Basel III regulation which encourages financial institutions to increase liquidity and reduce leverage through strengthened capital requirements. Finally along with financial institutions and governments, I believe consumers and individuals themselves are partly to blame for the irresponsibility leading to the financial crisis. Individuals should be responsible for the levels of debt they take on and take responsibility for repayment of this debt. As individuals took on too much debt, mainly in the form of mortgages it led to the crisis. In order to prevent this there may be a strong argument for more stringent credit rating controls imposed by rating agencies as individuals tend to be optimistic when it comes to accumulating debt.

Phil Angelides, chairman of the Financial Crisis Inquiry Commission conceded in his final report on the causes of the crisis, “we conclude first and foremost that this crisis was avoidable." (cited by Rooney, 2011). After briefly assessing the causes of the crisis in this blog, I would agree that the financial crisis could have been avoided, or at least its consequences could have been reduced. I believe firms could have imposed more stringent corporate governance controls to control their policies along with ensuring leverage and liquidity levels remained reasonable. I believe this could have also been supported by stricter legislation imposed on financial institutions by governments, mainly in the ‘shadow industry’ of investment banks and hedge funds. I believe firms could have incentivised and remunerated staff in different ways, to encourage them to focus on longer term wealth maximisation aims in line with shareholders rather than a short term risk taking approach. Finally I believe the credit rating agencies could have imposed more stringent controls on individuals to ensure that credit defaults are minimalized. I also believe that consumers could have taken more responsibility in terms of the amount of debt they took on to ensure that they were in satisfactory positions to repay debts, which also would have been aided by stronger credit controls. I believe that if all parties took such steps, the financial crisis would not have been able to reach the severity level it did, and therefore financial institutions, individuals and the government should consider such steps in the future to prevent a similar worldwide crisis.

References in this blog

Cadbury, A. (1992) The Report of the Committee on the Financial Aspects of Corporate Governance. London: Gee.

Rooney, B. (2011) “Financial Crisis Was Avoidable: FCIC.” Retrieved from: http://money.cnn.com/2011/01/27/news/economy/fcic_crisis_avoidable/index.htm (Accessed 16/03/2013)

Would a ‘megamerger’ between Vodafone and Verizon be a good thing?

It has been widely reported this week that two of the largest communication firms in the world, Vodafone and Verizon, are in talks regarding a merger. Some reports have touted this as a ‘megamerger’ worth figures in the region of $250 billion which would result in one of the largest mergers in history, creating a communications giant. Such deal would be considered a horizontal merger whereby two companies in similar lines of activities combine (Arnold, 2008), which could result in great benefits to a number of parties. With Vodafone shares jumping 7% this week on the back of such rumours, this blog aims to analyse the potential benefits of such a deal.

Whilst there are a wide range of reasons to merge two companies, a key reason for a horizontal merger is the benefits achieved through economies of scale. Economies of scale are essentially the cost advantages a firm achieves through its size. Whilst Vodafone and Verizon are likely to experience economies of scale currently due to their large respective sizes, such merger could enhance this further as size would increase. Another key reason for such merger could be the increase in market power achieved by the newly created firm who would essentially become, as mentioned, a communications giant within the industry. Market power is also enhanced as competition is reduced, as these two firms who previously may have seen each other as competition are now working in synergy. There could be an element of risk diversification in this deal, as although the companies operate in the same industry, Verizon focuses predominately on broadband communications and Vodafone focuses predominately on telecommunications operations. This factor could also open up a wide range of opportunities for the firm as sharing knowledge between these two areas could allow the firm to excel in all areas of the industry along with the sheer size and scope of the organisation potentially allowed the new firm to consider entering new markets. There could also be a wide range of other benefits to the new firm resulting from the merger in terms of physical resources, human resources and financial resources as the firm would have access to a wider range of assets, a wider range of staff and therefore knowledge pool, along with generating greater sums of cash and in turn greater profits.

The above paragraph suggested some benefits I believe Verizon and Vodafone would experience from merging the two firms, however I feel it is also important to consider the potential benefits on other stakeholder groups. Firstly would consumers benefits from the new global giant? Well in theory if the firm achieved greater economies of scale and increased efficiency, thus reducing costs, they would be in a position to reduce prices. However this may not actually be the case, as instead the firm may be in such a dominant position over consumers and other firms due to increased market power that they instead raise prices and reap the rewards through greater profits. However, the new global giant created is likely to have access to a greater research and development department which may benefit consumers through new products for example to meet ever changing demand. Another key stakeholder group is the employees of both firms involved. It is often the case after a merger that a number of staff roles become redundant as roles in the newly created firm are shared. However it depends on the strategy the firm wishes to follow, as increasing the size of the firm could alternatively result in jobs actually being created. There are also a wide range of other stakeholders who would be affected by the merger of Verizon and Vodafone, such as shareholders who in this case may gain through increased share price of the new global giant, advisors who are likely to gain through high fees resulting from the transaction, governments who will receive taxes from the organisation and local communities who may benefit from increased employment opportunities and improved infrastructure for example.

Whilst this blog has considered the benefits of a potential merger between Verizon and Vodafone, there is of course the flip side, as such merger is likely to result in a number of potential disadvantages. As mentioned there may be employment implications such as jobs becoming redundant due to overlapping job roles. There may also be other issues to consider such as the new company exploiting tax loopholes to avoid payment of tax in a number of ways. However along with these issues there are likely to be vast disadvantages resulting from what would become one of the largest companies in the world, not just the industry. Whilst the new firm would not be a monopoly, it would possess significant power in the communications industry which it could use in a number of ways. For example the firm would have more power over suppliers and more power over market prices which benefits the firm at the expense of suppliers and customers. Such a large firm may even experience diseconomies of scale, as production costs may instead increase due to the size of the organisation. Other typical disadvantages of mergers include ‘culture clashes’ whereby the two firms corporate cultures struggle to integrate, leading to friction within the new organisation or poor ‘consumer perception’, whereby consumers may not like the idea of such a large corporation in the industry and choose not to use it.

So, should they do it? Well obviously the whole process and decision is a little more complex than I have made it seem in this short blog however the concept is true. In this case, a global giant would be created, which based on the evidence suggested in news reports and rumours this week, is a realistic prospect. I feel it would be very interesting for such a large merger to occur. I personally feel the key benefits would be through aspects such as R&D as such a giant would be in a position to create new products which could potentially change the communications industry as a whole. I also feel that if power and dominance was not exploited, then the firm could achieve benefits in the form of economies of scale which could be reflected in areas such as prices, thus benefiting consumers. It is not really possible to tell the impact on areas such as employment, however the potential for job creation is present. I also feel that the shareholders would benefits from such a merger, arguably a view supported by the market based on the 7% increase this week simply on the back of ‘rumours.’ It will be interesting to see what happens regarding this merger in the near future, but in my often optimistic view, I would support it.

Reference in this blog

Arnold, G (2008) Corporate Financial Management. Fourth Edition. Harlow. Financial Times, Prentice Hall.

Would it be beneficial to return to a Bretton Woods style system?

Back in the 1930’s it became almost common practice for countries to deliberately devalue their currencies in order to encourage business from abroad, whether that be in the form of increasing exports or encouraging foreign direct investment (FDI) within their nation. In order to avoid an economic disaster, world leaders and economists met in the mountains of New Hampshire in July 1944 at a place called ‘Bretton Woods’ to establish a system to essentially stabilise the economy.

Throughout these days a system was established which incorporated a number of factors. Firstly the international monetary fund (IMF) was set up to provide short term help for counties with balance of payments difficulties. Secondly the World Bank was set up which provided long term loans to nations and therefore facilitate investment mainly for production purposes. Thirdly the international trade organisation (ITO) was set up to compliment both the IMF and the World Bank, designed with the intention of encouraging free trade. However along with setting up  these organisations, the main outcome of the ‘Bretton Woods’ meeting was to fix each nation’s currency against the US Dollar, which itself was underpinned by the price of gold. This system was designed to remove foreign exchange risk (currency risk), promote international trade and increase globalisation, and in the main, until its demise in 1971, worked reasonably well.

So the main focus of this blog is to consider whether it would be beneficial to return to a system similar to that of Bretton Woods. Now obviously there would be no need to create organisations such as the IMF, World Bank or ITO as these have already been established, however what would be the implications of returning to a world of fixed currencies rather than floating currencies?

I suppose to answer this question we should look at the benefits and negatives resulting from the original system. Firstly there would be the implication of choosing which currency to tie to gold, to essentially fix every other price to. Back in the old system, the US Dollar was used, which gave the United States’ currency a dominant position. However global central banks deliberately pegged their currencies at a low level in order to support exports to the US which lead to the accumulation of massive dollar reserves in the hands of central banks. As central banks held vast quantities of surplus dollars, this meant the US cost of borrowing decreased, allowing it to consume beyond its means, strengthening its economy further against others. In theory this compromised the existence of the Bretton Woods system in the first place, which set out to avoid the problem of deliberate devaluation of currencies. If we did look to return to such a system, such problems are likely to occur again, as there has to be some form of ‘negotiation’ when fixing the currencies which nations are likely to turn in their favour.

Another key problem was that over time the world economy grew and needed more liquidity or reserve assets. Also as the world economy grew, the increased world demand for the dollar as reserve assets meant that US had to maintain increasing trade deficits. As the US was forced to swap dollars for gold, it had to admit that it could no longer keep its pledge to exchange gold for $35 per ounce. Between Bretton Woods’ establishment in 1944 and its demise in August 1971, the U.S. exported almost half of its gold reserves. In the 12 months leading up to the end of Bretton Woods, the Fed lost nearly 15% of its total gold reserves. Given this, it would have to be assumed that the Bretton Woods system would not be able to be implemented again, as no single nation would allow itself to be fixed to the price of gold based on the evidence regarding the Fed losing a vast quantity of its gold reserves.

However whilst this blog has assumed the Bretton Woods system was negative, it actually worked reasonably well through its existence, thus creating a potential argument for its reincarnation. As mentioned foreign exchange risk between currencies was removed. This means that exposures such as transaction risk, translation risk and economic risk were also removed which encouraged investment in foreign nations, thus promoting international trade which led to globalisation. Therefore if such a system was reintroduced, it would arguably lead to increased FDI across the world. When applying this to Dunning’s (1988) eclectic paradigm, such ownership, location and internalisation advantages may exist however firms may be discouraged from investing in nations which traditionally have unstable currencies. However under a Bretton Woods style system, raw material seekers or product efficiency seekers for example, may be more encouraged to invest in nations which may otherwise have had unstable currencies as this risk is removed.

However whilst it may be a ‘nice’ idea to return to the Bretton Woods system, in reality it would never be implemented. In my opinion, no nation would agree to be the main nation and therefore fix its price to gold, as maintaining trade deficits in situations whereby countries wish to purchase gold reserves could ultimately lead to the collapse of a nation’s economy. Also it would reduce liquidity as the foreign exchange market would essentially become non-existent along with arguably the main problem being actually deciding upon the price to fix each individual currency at. I believe that in the current world economic climate, FDI and therefore globalisation will remain without the need for a new system, as companies are constantly seeking nations to invest within which may have raw material, production efficiency or knowledge advantages for example. The potential for FDI is also constantly being strengthened, an issue highlighted earlier this week when David Cameron travelled to India to sign trade agreements, encouraging investment between nations.

Reference in this blog

Dunning, J. (1988) The eclectic paradigm of international production: A restatement and some possible extensions. Journal of International Business Studies. Volume 19 Issue 1. pp. 1–31.