Banks don’t always follow basic financial principle

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Banks don’t always follow basic financial principle.

At Bond University, where yours truly still studies and hopes to acquire his 5th degree, we learn about a basic financial principle.  We call it the “matching principle”.

The matching principle is one of the fundamental backbone of a wide range of financial instruments and markets. The principle states that short term assets such as a working capital and inventories should be funded with short term liabilities. For example if a company is purchasing stock (which is an asset) that the company will use over a short time before it manufactures the products and then sells them, the company should need only a short term loan (liability) to fund the purchase of the stock. Like an overdraft.

The matching principle goes on to state that longer term assets should be funded with equity and long liabilities. For example a company may purchase a new factory and manufacturing equipment, and it is expected that these assets will generate income for the next 10 years. To fund the purchase, the company should issue equity and a long term debt such as bonds.

While the matching principle may be regarded as a fundamental principle of finance, it is interesting to note how often it is disregarded.

An underlying problem related to the global financial crisis was a significant increase in the number of subprime housing loan borrowers who defaulted on their housing loan repayments.  Subprime loans exist when a Bank minimises or even waives normal lending criteria in order to advance a loan to a party who otherwise could not obtain a loan.

IN the USA in particular, a large number of providers of housing loan finance had raised the funds necessary to provide long term subprime housing loans by issuing short term securities in the money markets. There was a fundamental maturity mismatch.  This mismatch was sustainable only as long as confidence remained in the money market.  However, the GFC removed that confidence and investors became reluctant to buy the short term commercial paper being issued by the housing loan lenders.

It is interesting to note how often a financial crisis is essentially a failure to apply the basic principle of finance.

Let us go back to the 2008 Global financial Crisis. Short term finance that was available through the money markets virtually ceased as a result of uncertainty in relation to risk deriving from the so called subprime market collapse. Quite a number of financial institutions had been funding longer term instruments with short term finance in the money markets.

When this source of finance was suddenly no longer available, the institutions experienced a significant liquidity problem and some institutions failed or were taken over.

 

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