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Market ForceMarket Force
A View Of Distressing Reality
MARKET FORCE
June 2007
16 March 2009
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy
Housing
Consumers Workers
Information
TourismLarge
Companies
Retail
HOUSEHOLDS
SERVICES FACTORIES
Medium
Companies
Small
Companies
Children
Assets
Construction
Cars
Education
Culture
Medical
Utilities
Manufacturing
The Real Economy is
driven by consumers
spending money on theirbasic and discretionary
needs, and purchasing
tangible and intangible
assets that serve their
current and future
purposes
The goods and services
that meet these needs
are supplied bymanufacturers and
service suppliers, who
also function as the
employment providers
for the household wage-
earners
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy
The interaction between
these three dynamics is
the primary source ofvalue creation (GDP) in
the economy, and must
be the core focus of any
economic progress
This model has existed
in one form or another
throughout history
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy + Financial Sector
Assets Liabilities
Risk
Capital
Customer
Deposits
Consumer
Loans
Corporate
Loans
Mortgage
Loans
Cash
TRADITIONAL BANKING
Traditional banking is a relatively new phenomenon that has developed in a supporting role to serve valuable
functions that support the Real Economy :
! Storage of money as a unit of exchange (Customer Deposits = Savings)! Transaction services that simplify the payment for goods and services! Providing of loans to finance the purchase of assets, goods and services
These functions are provided almost entirely by using Other Peoples Money (OPM)
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Economic and Financial Interaction
TRADITIONAL BANKING
Traditional Banking surrounds much of the real economy, which has come to depend vitally on its
smooth functioning
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Economic and Financial Interaction
TRADITIONAL BANKING
One of the key functions of Traditional Banking is to recycle the funds generated by the Real
Economy, providing liquidity and the opportunity for value creation (GDP)
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Economic and Financial Interaction
TRADITIONAL BANKING
However, it is important to remember that Finance is not the Real Economy
It is a derivative of the real economy
Without the real economy, Finance has no reason to exist
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Economic and Financial Interaction
TRADITIONAL BANKING
PRIVATE EQUITY
In principle, Private Equity can represent direct investment into companies and services, and in
this model it therefore directly supports the growth of the real economy - but it is also a
derivative function, and not a direct creator of GDP itself
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Economic and Financial Interaction
TRADITIONAL BANKING
PRIVATE EQUITY
LISTED EQUITY
Listed Equity provides capital to the real economy when companies actually sell their shares to
the market, but most of the time it only serves as a trading and valuing platform removed from
and derived from the real economy, and is not in itself a primary source of GDP
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Economic and Financial Interaction
TRADITIONAL BANKING
PRIVATE EQUITY
LISTED EQUITY
INVESTMENT BANKING
Likewise, Investment Banking is a derivative function assisting the allocation of capital (OPM) to
various financing or investing activities
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Economic and Financial Interaction
TRADITIONAL BANKING
PRIVATE EQUITY
LISTED EQUITY
INVESTMENT BANKING
TRADINGMost Trading is fundamentally
removed from the real
economy, and representstransactions with
no direct effect on
consumption
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Economic and Financial Interaction
TRADITIONAL BANKING
PRIVATE EQUITY
LISTED EQUITY
INVESTMENT BANKING
TRADING
DERIVATIVES
And Derivatives are actually . . .
derivatives of derivatives . . .
of derivatives . . .of derivatives
. . . furthest removed
from contributing to
real economic activity
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy + Financial Sector
Assets Liabilities
Risk
Capital
Customer
Deposits
Consumer
Loans
Corporate
Loans
Mortgage
Loans
Cash
CORRUPTED BANKING
Bonds
Borrowed
Money
Derivatives
Over the last several decades, as the financial sector has
become more sophisticated, the Traditional Banking model
has gradually become deeply corrupted :
Borrowed Money (especially short-term wholesalefinancing) has increased bank liability risks
Market instruments like Bonds and Derivatives have
changed the nature of the bank balance sheet
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
TRADITIONAL BANKING
Economic and Financial Interaction
These new embedded risks
were not immediately
obvious for thedanger they
created . . .
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
TRADITIONAL BANKING
Economic and Financial Interaction
. . . until failures elsewhere in
the financial system
created destructionof derivatives . . .
. . . that in principle
should not have spilled
over into Traditional Banking
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Economic and Financial Interaction
TRADITIONAL BANKING
A major consequence has been that Traditional Banking
has ceased to perform its vital function of recycling the
funds generated by the Real Economy, providingliquidity and the opportunity for value creation (GDP) . . .
. . . and in fact by causing a reversal of flows,
has instead been removing liquidity from the market
and destroying the activities of value creation (GDP)
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy + Financial Sector
Assets Liabilities
Risk
Capital
Customer
Deposits
Consumer
Loans
Corporate
Loans
Mortgage
Loans
Cash
CORRUPTED BANKING
Bonds
Borrowed
Money
Derivatives
INITIAL RESPONSES TO
Initial responses to the financial crisis were to try and protect the
banks . . . not the real economy :
Customer Deposits received government guarantees to
try and keep cash in the banks
Bank risk capital was refilled
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy + Financial Sector
Assets Liabilities
Risk
Capital
Customer
Deposits
Consumer
Loans
Corporate
Loans
Mortgage
Loans
Cash
CORRUPTED BANKING
Bonds
Borrowed
Money
Derivatives
SECOND-ROUND EFFECTS OF
But these actions did not address the real problems of banks :
Borrowed Money was not guaranteed and
wanted to flee
Bonds and Derivatives continued to collapse
in value
And little was done to maintain the primary Lending function
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy + Financial Sector
Assets Liabilities
Risk
Capital
Customer
Deposits
Consumer
Loans
Corporate
Loans
MortgageLoans
Cash
TRADITIONAL BANKING
OBSERVATIONS :
1. It has become obvious that governments are effectively obliged to guarantee bank deposits
2. This obligation will not go away in the future
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy + Financial Sector
OBSERVATIONS (continued) :
3. Huge injections of liquidity into the financial sector have not
translated into liquidity for the real economy4. Banks are actively disintermediating themselves from the
real economy in natural response to their balance sheet stress
5. Instead, they are focusing on absorbing the consequences of past errors
We need to "endure" a period of cyclical correction and capital consolidation
before real investment and lending activity can begin anew Banker viewpoint, 15 December 2008
Assets Liabilities
Risk
Capital
Customer
Deposits
Consumer
Loans
Corporate
Loans
Mortgage
Loans
Cash
CORRUPTED BANKING
Bonds
Borrowed
Money
Derivatives
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy + Financial Sector
Assets Liabilities
Risk
Capital
Customer
Deposits
Consumer
Loans
Corporate
Loans
MortgageLoans
Cash
TRADITIONAL BANKING
OBSERVATIONS (continued) :
6. Contraction of real-economy lending has become the cause of the economic contraction, not the consequence
7. The distressing reality is that without direct intervention, the real economy will be obliged to continue contracting
8. Economic contraction will create business failures, unemployment, and individual bankruptcies
9. Continuation of this process is a Death Spiral, feeding on itself with no clear benefit
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy + Financial Sector
Assets Liabilities
Consumer
Loans
Corporate
Loans
MortgageLoans
Cash
INTERVENTION BANKING ?
CONCLUSIONS :
1. The government already effectively owns the liability for Customer Deposits, which is the real money of the economy
2. With banks removing themselves from the market, it seems inevitable that the government must involve in real lending
3. This lending can be funded with the same Customer Deposits that the government has now taken responsibility for
4. And this lending should be structured with a suitable Risk Reserve that covers the practical default risks
Risk
Reserves
Customer
Deposits
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy + Financial Sector
Assets Liabilities
Consumer
Loans
Corporate
Loans
MortgageLoans
Cash
INTERVENTION BANKING ?
CONCLUSIONS (continued) :
5. This Back-To-Basics approach appears to have become inevitable regardless how you choose to dress it up
6. This is not a Korean problem it is a global and systemic problem manifesting in countries all over the world
7. Other countries are implicitly already starting to do this for example, U.S. and UK auto industry bailout attempts
8. The key issue is to ensure continued access to ordinary borrowing for consumers and small and medium businesses
Risk
Reserves
Customer
Deposits
UNAVOIDABLE SHIFT TO A NEW PARADIGM BASED ON OLD TRUTHS
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Real Economy + Financial Sector
Assets Liabilities
Consumer
Loans
Corporate
Loans
MortgageLoans
Cash
INTERVENTION BANKING ?
IMMEDIATE OPPORTUNITIES FOR KOREA :
1. Silver Bullet Credit Cards
2. Time Bomb Mortgages
3. Too-Short Corporate Loans
4. Working Capital Credit Lines
" Convert immediately to revolving credits / 5% minimum monthly payment" Convert immediately to 30-year monthly amortizing" Encourage conversion to 5~10-year monthly amortizing" Activate immediately for revolving financing of A/R at 80% advance rate
Risk
Reserves
Customer
Deposits
" REDUCE MATURITY RISKS (LIQUIDITY SHRINKAGE) FOR REAL ECONOMY PARTICIPANTS" INCREASE EXISTING LIQUIDITY FOR REAL ECONOMY PARTICIPANTS
5. Chaebol Squeeze Bill Payments " Activate Credit Central to buy chaebol notes and control issuance
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Key Issues - 1
TRADITIONAL BANKING
How to get the liquidity recycling machine working again at levels that match recent economic activity, even
while the financial sector is being restructured ?
Will it become necessary for governments to effectively direct financial lending ? That is what is alreadyhappening in the U.S., UK, France, Germany ?, China, Korea, and elsewhere . . .
Can Traditional Banking be expected to function effectively without the complete removal of the sources of
corruption ?
The implications of this would clearly be to require deposit-taking financial institutions to be completelyseparated from market-participating institutions, and NOT the other way round as the U.S. Government has
recently been encouraging with mergers of investment banks into bank holding companies
Because deposit-taking financial institutions must effectively be guaranteed by governments, and perhaps
directed by governments, what will be the relevance of their shareholders ?
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Market Force
Copyright 2001-2009, Market Force Company, All Rights Reserved.
Key Issues - 2
TRADITIONAL BANKING
Is there a need for the creation of new financial intermediation models that will be more reliable providers of
capital and liquidity to the Real Economy, and that can be less prone to amplifying cyclical downturns by
withdrawing liquidity from the market when it is most needed ?
What implications does all this have for the emergence or continued growth of newer intermediaries in the
financial system, including the Islamic Finance model ?
What implications does all this have for other layers of the financial system ?
Is there a valuable role for private capital in Business Development Funds (10 - 20 years time horizon) as
distinct from the current role of private equity in short-term leveraged buyout funds (3 - 5 years time horizon) ?
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Market ForceMarket Force
June 2007
1 August 2008