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Economic Cycle Refresh for Banks Understanding Impact, Risks, and Survival Strategies

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Economic Cycle Refresh for Banks Understanding Impact, Risks, and Survival Strategies VIEW POINT ECONOMIC CYCLE REFRESH FOR BANKS UNDERSTANDING IMPACT, RISKS, AND SURVIVAL STRATEGIES “What goes up must come down.” - Isaac Newton Throughout the history of economics, periodical ups and downs define the very nature of it. Behind revolving peaks and valleys, there is balancing act of supply and demand forever. Study of economic indicators often recognizes certain patterns of this cyclical nature of business of which Economic cycle is one of the most influential patterns. In a sinusoidal curve, between rise and fall of credit, this cycle depicts a true state of economics. In this study, nature of economic cycle is explained by taking note of historical evidences and current economic indicators. Based on the analysis further efforts has been made to determine if current economy is nearing the end of current cycle. Acknowledgements We would like to thank all the reviewers, approvers and technical writers for their participation and contribution to the development of this document. Special thanks to all the awesome people who had contributed their valuable tools, knowledge, experiences, and insights to the public using World Wide Web. Introduction In the third decade of eighteenth century, classical economics started recognizing the fact, that economic activities are periodic in nature. From middle of eighteenth century many notable economists started studying this pattern and by 1950, modern economics had completely convinced itself on the importance of economic cycles on everything around. Banking and financial institutions are the driving institutions of global economy and thus are the most sensitive towards the change of economic cycles. Without deep understanding of economic cycle, banks cannot sustain, operate and become profitable. But this understanding is nearing impossible to perfectly master, as there are thousands of factors and variables in economics - and considering complex interrelations and ever changing nature of those, no amount of efforts will be enough. But it is absolutely necessary to have a good understanding of the economic cycle and there is no escaping from it. Hence, in this paper, we have tried to explain basics of economic cycle to the reader, and then based on economic data, tried to understand the current phase in the cycle. This understanding is further used to determine the impact of current cycle on the banking industry and the best strategies to deal with the same. External Document © 2018 Infosys Limited Phases of economic prosperity are known as expansions and phases of economic downtrend are called recessions/depressions. The combination of these two phases of expansions and recessions is called the business cycle. Three phases of economic cycle are: A. Recovery Phase: This phase comes after a recession where evaluation is at the cheapest level where most of the companies are involved in proving their credit profile. What Is an Economic Cycle? depressions. The combination of these two with caution. Deterioration phase can phases of expansions and recessions is actually last for years and end of the Economic cycleB. Expansion Phase: Where we see increased borrowing and lending, means expansion and with increment in underlying called the business cycle. phase depends on the combination of contraction of borrowingasset value. and lending factors like weakening economy and between companies and investors. C. Deterioration Phase: Today we are in this phase. It is seen thaThree phases of economic cycle are: t we are through the best of the recession, steps taken by central banks, Significant swingscycles and proceeding with caution. Deterioration phase can act in economic parameters ually last for years and end of etc. 1. Recovery Phase: This phase comes are observed naturallythe phase depends on the combination of factors like weakening in The United economy and recession, steps after a recession where evaluation is at Also the question arises as to how investors States and all othertaken by central banks, etc. modern industrial the cheapest level where most of the should be positioning their portfolios economies, though their duration may companies are involved in proving their vary. During peak, industries are growing in this environment. It is better suited credit profile. and unemployment is lower; but in few for focusing on capital preservation and years duringAlso the question arises as to h phase of contraction, most ow investors should be position2. Expansion Phase: Where weing their portfolios in this environment. It see generating a reasonable return rather than industriesis better are not suited operating for well focusing with high on capital increased preservation borrowing and and gener lending,ating with a reasonable trying return to maximize rather earnings. than trying to maximize earnings. levels of unemployment. increment in underlying asset value. Below diagram shows the phases of PhasesBelow of economic diagram prosperity shows are the known phases of 3. economic Deterioration cycle. Phase: This Today diagram we areis in just for economic depiction cycle. and This does diagram not is just for as expansionscorrespond to any data. and phases of economic this phase. It is seen that we are through depiction and does not correspond to any downtrend are called recessions/ the best of the cycles and proceeding data. The Economic Cycle 1.2 PEAK PEAK 1.0 R E A 0.8 L O 0.6 U T 0.4 P U T 0.2 TROUGH TROUGH TROUGH 0.0 year1 year2 year3 year4 year5 year6 year7 year8 year9 year10 year11 year12 Figure 1: Theoretical depiction of economic cycle production. So more the man hours more activates increase. Leading indicators which willFigure 1: Theoretical depi ction of economic cycle is the manufacturing and more is the explain economic cycle? 4. New orders for plant and equipment: demand indicating the positive trend in As new orders come in as per increased There are numerous factors across the the economy. demand during time of expansion,5 more globe, which are used quantatively and 2. New claims for unemployment insurance: plants and equipment’s are required. An methodically in different studies for The more the claims indicate the slowness increase in plant and equipment purchase determining the economical state. In the in the economy, as unemployment by factories, generates more employment, below section we are explaining few of the increases. An increase in unemployment more supply and more industrial lending. most important factors in the context of this rate is usually not a good sign of economic 5. Building permits for private houses: More paper. health. new houses again increases employment 3. Consumer spending: With increased for so many indirect jobs and also more Leading Indicators: consumer spending, new orders come in to spending by customers also indicate 1. Hours of production workers in manufacturing industry that in turn creates positive flow in the economy. Also to note, manufacturing: Increase in hours more number of jobs. This is a sign of a real estate has been a great contributor to indicates more work and more good economic state as positive economic GDP of the country. External Document © 2018 Infosys Limited 6. Fraction of companies reporting increasing, that generates opportunity increasing inflation and lower slower deliveries: When a sector or for business to greater revenue and purchasing power. industry reports slower deliveries for profit margin, along with increases risk 9. Money growth rate: It indicates the few consecutive quarters, that leaves a appetite for fresh investments. grim outlook on the economic growth inflation in the economy. Inflation prospect. Eventually if this trend 8. Change in commodity prices: This is zero if money supply is equal to continues, slowness in the economy indicates the inflation in the market money demand. Positive inflation is a may lead to a breakdown and recession and thus plays its part in deciding the good sign for economies, but only up period starts. spending power of consumers in the to a threshold. Less inflation denotes 7. Index of consumer confidence: This is economy. For example, price of oil and poor return on capital investments, a very important point indicating the gas sector has direct impact in profit and very high inflation denotes investing power of consumer into the margins of any large industry, rise in weakness in supply demand system market. When consumer confidence is edible commodities points towards underlying. Below figure can summarize the co relations and impacts on the current economic cycle of the above indicators. Increased Increasing Production "Increased supply Increased man hours manufacturing UPTREND hour in manufacturing and demand " output "less consumer Increasing claims for more no of insurance Increased spending , and DOWNTREND unemployment insurance claims unemployment demand" Increasing consumer fresh set of more plants and more UPTREND spending manufacturing orders equipments employment Increasing orders for plant more investment Increased demand more employment UPTREND and equipment and spending Increasing building increased increased lending increased GDP UPTREND permits for private houses employment Increasing companies Lower supply and lower purchasing lower wages DOWNTREND reporting slower deliveries demand power Increasing Index of more investment more business higher consumption UPTREND consumer confidence and risk appetite growth Increasing commodity lesser purchasing less profit by Higher inflation DOWNTREND prices power industry Increasing money growth
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