Since starting of this blog, I have tried to cover the topics for the people like myself, those who understand only basics of finance and not the luscious terms like hedge funds, leveraged buy outs, mortgage funds etc.
So we will be writing a series on the importance of banks, how they effect our financial ecosystem. In this first post, let us quote Ilian Mihov, Professor of Economics at INSEAD, France. Here is how he explains it -
Banks fulfill a very important role in the economy by matching borrowers and lenders. When we deposit $100 in a bank, the bank keeps, at most, two to three dollars in its vaults (in fact the money is often in the central bank), the remaining $98 or so is lent to a borrower.
Most businesses require loans for their normal operations. When the banking sector does not work properly, businesses cannot get loans and they have to curtail their production and lay off workers. As they curtail production, they demand fewer products from their suppliers and therefore their suppliers have to reduce their output and fire workers. If manufacturers cannot sell their goods because the firm downstream does not need as many products as before, they cannot generate enough revenue to repay their earlier loans. Businesses go bankrupt and banks experience further problems as their balance sheet deteriorates due to non-performing loans. At this point, banks want to lend even less because of the uncertainty generated from bankruptcies. As they lend less, the vicious circle continues – with producers cutting production and firing workers.
On the top of this, depositors start worrying about their deposits because the non-performing loans have made some banks go belly up – your bank has lent out your money to borrowers who cannot return it. Depositors start withdrawing their cash and banks have even fewer possibilities for lending as they have to hoard cash in case there is a run on the bank. If the financial sector does not work, the real economy can go into a deadly spiral and shrink by 30 per cent as during the Great Depression.
Last four weeks have sent the financial world in a full carnage, as bear guzzled up the giants who had been on bull rampage for quite some time now.
We are sure you would have read about what happened, how it happened and what can happen further, so here are some links to just epitomize the blood bath.
(All of these are either interactive or images)
(All of these are either interactive or images)
Journey of the four weeks of dominoes turmoil
Price-Earning ratios graph, indicating when its time for stock to bond market shift
How the Credit Crisis Unfolded
A timeline of bailouts and buyouts of financial companies in US and UK
Sources: NY Times website
You would have seen these notices outside shops
All Major credit cards accepted, Conditions apply
Condition: Bill should be atleast Rs.200
No return, No Exchange
2% extra on credit cards
This makes us wonder about the business model of a credit card and how the economies of a credit card transaction are placed between various entities involved in a transaction.
Ideally in a transaction, you would see two parties - an entity who pays and an entity who accepts; but to complete a credit card transaction you will need five entities to come and work in unison. (It may happen that some of these entities are same and not different)
Lets go through the last transaction you did when you bought that book for yourself. Say the book was of Rs. 100 and you paid through your ICICI Visa card and signed on the slip, showing HDFC name, which was kept by the merchant. Now as per the illustration below, Merchant would get back only Rs. 98.10 from Acquirer out of 100 and is paid 1.9% less. This 1.9% will now feed the rest of the three entities. And you will pay back full Rs. 100 to your credit card issuer, ICICI bank, at end of your billing period. But ICICI will give Acquirer (HDFC here), the one who placed the card reader in the shop, Rs 98.60 keeping Rs 1.40 to itself. So by now HDFC has already made Rs 0.50 (98.6-98.1). Now HDFC will give Rs. 0.07 to VISA while ICICI will give Rs. 0.08 to VISA.
Now above numbers are for transaction of Rs. 100 so use these numbers in percentage points and you get an idea of money interchanged per transaction in percentage. The numbers here are just illustrative and would change according to network, merchant type etc. But they do give a fair idea.
But then there are many ways of doing a non cash transaction these days: Credit card, Debit Card, Prepaid Card, PayPal/Google Checkout or Mobile payments...
The snapshot below lists the approximate processing fees charged by each major player in various payment instruments (ranging from Cash/Check to Credt & Debit Cards and Mobile Payments).
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