FINANCE Essencial Finance.Pdf

01 Essential Finance 10/11/06 2:21 PM Page i Essential Finance 01 Essential Finance 10/11/06 2:21 PM Page ii OTHER ECONOMIST BOOKS Guide to Analysing Companies Guide to Business Modelling Guide to Economic Indicators Guide to the European Union Guide to Financial Markets Guide to Management Ideas Numbers Guide Style Guide Business Ethics China’s Stockmarket Economics E-Commerce E-Trends Globalisation Measuring Business Performance Successful Innovation Successful Mergers Wall Street Dictionary of Business Dictionary of Economics International Dictionary of Finance Essential Director Essential Internet Essential Investment Pocket Asia Pocket Europe in Figures Pocket World in Figures 01 Essential Finance 10/11/06 2:21 PM Page iii Essential Finance Nigel Gibson 01 Essential Finance 10/11/06 2:21 PM Page iv THE ECONOMIST IN ASSOCIATION WITH PROFILE BOOKS LTD Published by Profile Books Ltd 58A Hatton Garden, London ec1n 8lx Copyright © The Economist Newspaper Ltd 2003 Text copyright © Nigel Gibson 2003 Developed from a title previously published as Pocket Finance All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of both the copyright owner and the publisher of this book. The greatest care has been taken in compiling this book. However, no responsibility can be accepted by the publishers or compilers for the accuracy of the information presented. Where opinion is expressed it is that of the author and does not necessarily coincide with the editorial views of The Economist Newspaper. Designed and typeset in EcoType by MacGuru Ltd [email protected] Printed in Italy by Legoprint – S.p.a. – Lavis (TN) A CIP catalogue record for this book is available from the British Library ISBN 1 86197 530 9 01 Essential Finance 10/11/06 2:21 PM Page v Contents Introduction vi The changing face of markets 1 A to Z 17 01 Essential Finance 10/11/06 2:21 PM Page vi vi ESSENTIAL FINANCE Introduction Essential Finance is one of a series of Economist books that brings clarity to complicated areas of business, finance and management. It is a guide to the increasingly complex world of money, financial markets and the things that revolve around them. It owes much to the entertaining and often irreverent guides to banks, bankers and international finance written over the years by Tim Hindle, a former finance editor and currently business features editor of The Economist. An introductory essay examines the changing face of markets: how stocks and bonds have become more important as sources of finance for companies, how financial institutions have expanded not just in size but also across borders and in the kinds of business they do. The complexity of corporate deals and the speed with which huge amounts of money are moved today have undoubtedly increased the volatility of markets and the risks for investors, risks that are at the same time made worse and spread by the use of derivatives (futures, options and the like). Following the essay is an extensive A to Z of terms widely used by those in finance and banking. Often the terms have dif- ferent meanings even for those within the same arcane world. In this section words in small capitals usually indicate a separate and sometimes related entry (although abbreviations such as eu also appear in the same form). Nigel Gibson March 2003 01 Essential Finance 10/11/06 2:21 PM Page 1 1 The changing face of markets f Rip Van Winkle had gone to sleep in the early 1970s and Iwoken up 30 years later, he would recognise little of today’s financial landscape. True, there are companies with sharehold- ers, and banks and stock exchanges; and there are still plenty of lawyers and bankers who help to transfer money from one pocket to another so that companies can raise the finance they need and business may be done. But the way the money is raised and the speed with which it is done have changed virtu- ally beyond recognition. Thirty years ago, banks were still the main source of finance for most big companies, especially in Japan and continental Europe. Today, for the most part, banks play second fiddle to the equity and bond markets for big companies; even in Germany and Japan, the part played by banks has diminished. Equity and bond markets have become more international and have ex- tended their influence in ways that would have been unimagin- able 30 years ago. Compared with their counterparts of even a decade ago, today’s financial institutions are not only more diverse, both geographically and in terms of their businesses, they are also better capitalised. In 1990, the biggest financial firms were commercial banks, most of them Japanese, whose main function was the taking of deposits and the making of loans. At that time, banks in continental Europe were typically engaged in a broader range of activities than their US counterparts which, under the Glass-Steagall Act, since repealed, had to choose between commercial banking, investment banking and special- ist financial services such as insurance. Nowadays, by far the largest firms are financial-services conglomerates. These combine commercial banking with a range of other financial services, such as underwriting bond and equity issues and advising on mergers and acquisitions. They also provide consumer finance and sell on loans to other investors, for example, by arranging syndicates, buying and selling derivatives, and issuing securities backed by mortgages, credit-card re- ceivables and the like. In 1990, the list of the top 15 financial 01 Essential Finance 10/11/06 2:21 PM Page 2 2 ESSENTIAL FINANCE firms by market capitalisation (as compiled by Morgan Stanley Capital International) was dominated by Japanese banks, the largest of which had a stockmarket capitalisation of $57 billion. A decade later, partly because of a spate of mergers among such firms, international financial-services groups took up most of the places; and the biggest (Citigroup) was then capitalised at more than $250 billion. The sheer size of the conglomerates has undoubtedly helped them to withstand the shocks that have beset the banking system since the dotcom boom turned to bust and stockmarkets began to slide. Between 1998 and 2001, according to the Federal Reserve, America’s central bank, telecommunications firms worldwide alone borrowed around $1 trillion. Many of these loans have since had to be written off because their borrowers went bankrupt. In quick succession in the United States, Enron, WorldCom, Global Crossing and others collapsed. Yet in contrast to previous setbacks following similar bouts of overexuberance and overinvestment, banks were able to con- tinue lending to companies that needed money. The growth of sophisticated debt markets also helped to reduce companies’ re- liance on bank credit and equity to finance their operations. As a result, the US economy in particular was able to maintain a faster pace of growth than many had feared. That J.P. Morgan Chase was able to absorb the billions of dollars in losses that resulted from the collapse at the end of 2001 of Enron, an energy-trading company, speaks volumes not just about the size of J.P. Morgan Chase’s balance sheet, but also about its ability to spread the risk by selling derivatives to other investors. In the 1980s, a loss on the scale of Enron, then one of the world’s biggest companies, might have toppled Texas’s banking system. In the event, Texas was spared by the deregu- lation of state banking laws that subsequently took place, which allowed J.P. Morgan Chase (itself an amalgam of two big banking groups) to buy Texas Commerce Bank, one of Enron’s biggest lenders. It is true that banks have successfully shifted a large proportion of their risk on to others, and this has helped them to withstand a welter of shocks internationally. But are banks really as adept at diversifying this risk as they like to think? Are those to 01 Essential Finance 10/11/06 2:21 PM Page 3 THE CHANGING FACE OF MARKETS 3 whom they are passing the risk capable of managing it, particu- larly if markets remain volatile? In short, could the shift from a system reliant on banks to one based largely on markets contain dangers of its own? Insurers at risk One worry is that insurance companies – not always the most sophisticated of investors – have taken on part of the risk that banks and other intermediaries in the financial markets are shedding. Swiss Re and Munich Re, two of the world’s biggest insurers, between them account for a large proportion of credit derivatives outstanding. Credit derivatives are securities that allow banks to pass on to other investors the risk that some of their borrowers will default. Insurance companies have also been big buyers of asset-backed securities, financial instruments backed by pools of loans and other forms of debt. If insurance companies were unable to meet their liabilities and went bust, there is a danger that the problems would rebound on the banks. Another worry is that, with fewer and larger international banks, the pressure to succeed on even the best-managed banks may reach a point where they make mistakes on a colossal scale. Consolidation also brings dangers of its own. Take the foreign-exchange markets. In 1995, 20 banks in the United States accounted for 75% of foreign exchange traded; six years later, the number was down to 13.

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