So...what is finance all about?

In this teaser for the web-series I made last year, the all-knowing finance professional Mr Sikka says ‘Finance is when savers invest in the real economy…hedge their risks through various financial instruments…and understanding your risk profile by coming up with optimum asset allocation.’ What??!!

Sikka is not wrong. But because he, like other finance professionals, talk in jargon…and the small matter of the Global Financial Crisis and the following Great Depression…the non-finance professionals either think finance people are really smart or really dumb. Like many other things, the reality is in between. But first things first….what is finance??

Let me attempt to explain through a stick figure illustration.

The basic plot

In the real economy, people produce products and services that other people want to consume, using labour, raw material and machinery, all of which require capital. What should be produced, by whom, at what cost, and sold at what price – all these are the subject of economics (and there are plenty of economist jokes). In finance, we want to know how the producer gets the capital. Essentially, the producer has to ‘finance’ the venture by borrowing money from other people who have excess capital at the time, with a promise to return it with interest, kind of like an IOU note.

But there are risks. The producer may intend to return the capital, but the venture may not turn out well. Or he may not intend to stick to the promise - we don’t know for sure when he takes the money. He may offer collateral or not. The collateral may not be worth as much later. The collateral may not be enough to cover the amount needed. Hence, the investors may end up taking an ‘equity’ stake in the venture for their money, knowing fully well that equity will rank last after all the debts have been paid off in the case the venture is wound up.

All these risks need to be managed. The simplest way is to spread it. The producer usually takes small amounts from a number of different people such that the risk is spread over a wide group.

The risk is also reflected in the ‘interest rate’ charged for the borrowing, or the ‘required rate of return’ for the equity stake. These are negotiable. They may fluctuate based on what different investors perceive of the risk inherent in the venture. They may also reflect investors’ situations depending on whether they are flush with cash or having financial difficulties of their own.

Investors’ situations may change after having invested in the ventures. They can sell their IOU notes or equity stakes to other investors who are willing to take them on but perhaps at a different interest rate or required return. The investors can negotiate the terms on which they can trade.

The players

The producer doesn’t know the people with excess money. So he goes to a ‘financier’ - the person who finances the venture. The financier may put in his own money in the short term, but then he arranges the capital from other people who have it in surplus to their then needs.

The financier who puts in his own money is called a ‘banker’, though it turns out that his own money is not actually his, but that of a large number of other people who have deposited it with him for safekeeping. Hence, the banker has to be very conservative in his lending. He makes a living from the margin between the interest rate he has promised to the depositors and that he has offered to the producer.

If the venture is a bit riskier than what a conservative banker would be comfortable with, the producer can approach an ‘investment banker’ to act on his behalf and approach a number of rich investors to raise the capital. The investment banker can be a bit more flamboyant as he sells the dream of the successful venture to rich investors. He may even encourage them to take a stake in the venture rather than just lending. He gets paid commissions from the producer so the more he sells the venture for, the more commission he makes.

There are many types of rich investors. Some could be other producers sitting on some extra capital for the time being, but mostly they are ‘fund managers’ who manage the pooled savings of a large number of small investors. The fund manager invests in a range of producers, both through debt and equity. He charges a small fee on an ongoing basis to the small investors, so he wants to keep growing the amount of money he manages.

There are some investors who wish to invest directly rather than through pooling with other investors; they can do that as well, usually with the help of stockbrokers and financial advisers. Interestingly, sometimes the investment bankers moonlight as stockbrokers, and the bankers as financial advisers, ignoring the conflict of interest that this presents.

The market

Now imagine the sheer number of producers in this world who are looking for finance for their ventures, whether it’s to start a new venture, or to expand an existing one. It would be hard to find one another. So everyone agrees to meet at a designated spot and time, called the primary market. Remember, investors could also trade their IOU notes and equity stakes; the place they meet is called the secondary market because they are now trading second-hand goods.

The market used to be a physical location but now is a bunch of interconnected computers. There are markets for different types of risks - the borrowings ie the debt market and equity stakes ie the stock market.

It’s hard to track all the prevailing prices (the interest rates and required returns) of all the ventures in the world. So various stalls put up the prices of their biggest ventures and calculate the weighted average- this is called an index. The movement in the index indicates whether the demand for the ventures is up or down on any given day.

We are the investors

Obviously this is a simplified version of real life, but hopefully it highlights the role of the finance industry and some of the different players within it.

Now replace the image of individuals with institutions. A bank and an investment bank help corporations with finance but get paid very differently and hence, act very differently. A ‘universal’ bank has banking and investment banking operations under the same umbrella, but they are usually separated by ‘chinese walls’. So are the investment banking and stockbroking operations but were proven not to be in the past.

Most importantly, whose money is being lent and invested in these corporations? The ‘rich investors’ mentioned are professional institutional investors such as mutual funds, private equity/venture funds etc which pool savings of individual investors as well as those of other institutional investors called ‘asset owners’ such as pension funds, endowment funds and insurance companies. The asset owners themselves pool retirement savings, donations and premium payments from individual investors. Government agencies and sovereign wealth funds represents tax-payers’ money. So most savings are ultimately those of individuals.

This means we are the investors. When we deposit our savings in a bank, take out an insurance policy, invest in mutual funds or in stocks and bonds directly etc, we are financing corporations which in turn, make productive use of it and pay our wages, interest and dividends. Of course, we are doing all this to manage our own cash flows over our lifetimes – we borrow when we are young against our earning capacity, we save in our mid-life and then we drawdown our savings in our retirement. The mediums we use to do this – the bank, insurance, mutual funds, stockmarket etc – represent the finance industry.

We should be not intimidated by either the corporations, or the finance industry. Instead, we should take an active interest in how they can do their functions effectively, which ultimately helps us manage our lives.

Let me know what confuses you about finance...

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