Category Archives: Management

The (other) deleveraging: What economists need to know about the modern money creation process

Manmohan Singh is a Senior Economist at the IMF in Washington DC.  He continues to write extensively on topical issues including  deleveraging in financial markets, rehypothecation of collateral, and counterparty risk in OTC derivatives. He was the first to identify the role cheapest-to-deliver bonds as a proxy for recovery value in CDS instruments.

Peter Stella is Director of Stellar Consulting LLC providing macroeconomic policy advice and research to central banks, governments, and private clients in Asia, Europe, the United States and Latin America.

This article is republished from and in accordance with the policy

The world of credit creation has shifted over recent years. This column argues this shift is more profound than is commonly understood. It describes the private credit creation process, explains how the ‘money multiplier’ depends upon inter-bank trust, and discusses the implications for monetary policy.

One of the financial system’s chief roles is to provide credit for worthy investments. Some very deep changes are happening to this system – changes that surprisingly few people are aware of. This column presents a quick sketch of the modern credit creation and then discusses the deep changes are that are affecting it – what we call the ‘other deleveraging’.

Modern credit creation without central bank reserves

In the simple textbook view, savers deposit their money with banks and banks make loans to investors (Mankiw 2010). The textbook view, however, is no longer a sufficient description of the credit creation process. A great deal of credit is created through so-called ‘collateral chains’.

We start from two principles: credit creation is money creation, and short-term credit is generally extended by private agents against collateral. Money creation and collateral are thus joined at the hip, so to speak. In the traditional money creation process, collateral consists of central bank reserves; in the modern private money creation process, collateral is in the eye of the beholder. Here is an example.

A Hong Kong hedge fund may get financing from UBS secured by collateral pledged to the UBS bank’s UK affiliate – say, Indonesian bonds. Naturally, there will be a haircut on the pledged collateral (i.e. each borrower, the hedge fund in this example, will have to pledge more than $1 of collateral for each $1 of credit).

These bonds are ‘pledged collateral’ as far as UBS is concerned and under modern legal practices, they can be ‘re-used’. This is the part that may strike non-specialists as novel; collateral that backs one loan can in turn be used as collateral against further loans, so the same underlying asset ends up as securing loans worth multiples of its value. Of course the re-pledging cannot go on forever as haircuts progressively reduce the credit-raising potential of the underlying asset, but ultimately, several lenders are counting on the underlying assets as backup in case things go wrong.

To take an example of re-pledging, there may be demand for the Indonesia bonds from a pension fund in Chile. As since these credit-for-collateral deals are intermediated by the large global banks, the demand and supply can meet only if UBS trusts the Chilean pension fund’s global bank, say Santander as a reliable counterparty till the tenor of the onward pledge.

Plainly this re-use of pledged collateral creates credit in a way that is analogous to the traditional money-creation process, i.e. the lending-deposit-relending process based on central bank reserves. Specifically in this analogy, the Indonesian bonds are like high-powered money, the haircut is like the reserve ratio, and the number of re-pledgings (the ‘length’ of the collateral chain) is like the money multiplier.

To get an idea on magnitudes, at the end of 2007 the world’s large banks received about $10 trillion in pledged collateral; since this is pledged for credit, the volume of pledged assets is a good measure of the private credit creation. For the same period, the primary source collateral (from hedge funds and custodians on behalf of their clients) that was intermediated by the same banks was about $3.4 trillion. So the ratio (or re-use rate of collateral) was around 3 times as of end-2007. For comparison to the $10 trillion figure, the US M2 was about $7 trillion in 2007, so this credit-creation-via-collateral-chains is a major source of credit in today’s financial system. Figure 1 shows the amounts for big banks in the US and Europe.

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The Authors

Manmohan Singh is a Senior Economist at the IMF in Washington DC.  He continues to write extensively on topical issues including  deleveraging in financial markets, rehypothecation of collateral, and counterparty risk in OTC derivatives. He was the first to identify the role cheapest-to-deliver bonds as a proxy for recovery value in CDS instruments. Manmohan has led workshops for the IMF on strategic asset allocation and regulatory proposals to official sector policy makers. His articles have regularly appeared in Financial Times, Wall Street Journal, Euromoney, RISK, Journal of Investment Management, etc. His work experience covers several countries including U.K., U.S., Chile, India, Japan,Hungary, Poland,the Gulf countries and more recently peripheral Europe.

He holds a Ph.d. in Economics and a MBA from Univ. Illinois (Urbana-Champaign). He received his B.S. (magna cum laude) from Allegheny College, Pennsylvania. He was previously with ABN Amro Bank’s emerging market syndicate team (Amsterdam/London).

Peter Stella is former head of the Central Banking and Monetary and Foreign Exchange Operations Divisions at the International Monetary Fund. Currently Director of Stellar Consulting LLC providing macroeconomic policy advice and research to central banks, governments, and private clients in Asia, Europe, the United States and Latin America.


FINANCIAL VIABILITY: Your Yardstick for Organization Achievement, Part 1

Dr. John Psarouthakis is a Distinguished Visiting Fellow-Professor, Institute of Advanced Studies in the Humanities, University of Edinburgh, Scotland. Founder and former CEO, JPIndusries,Inc., a Fortune 500 industrial corporation. He is the Executive Editor of

Most employees, the media, and even entrepreneurs measure success by sales and sales growth. Most “lists” like INC 500 and FORTUNE 500 rank companies this way. In earlier articles we discussed pitfalls of this approach. But if banners and plaques are not a good measure of success, what is? Seasoned business owners realize that profits and asset growth provide better assurance of a firm’s long term survival and ability to thrive. Liquidity, or the availability of cash, is also a hallmark of the well-run business.1

What does financial viability mean? How well does your company stack up? By taking a few minutes to answer the following questions, you get a quick feel for this issue.

I. Liquidity and cash flow:
Question 1. Liquidity. How would you describe your current cash position (cash in the bank, whether obtained by a bank loan, retained earnings, or from start-up capital):
[1] Significant liquidity, available for major investment–e.g., a new plant, building, large piece of equipment
[2] Some liquidity, available for minor investment–a new truck, smaller piece of equipment, office equipment
[3] Little liquidity, available only for high priority items to keep current operations going
[4] Very little liquidity– difficult to cover even essential items to keep current operations going
The median firm in our study reported “some” liquidity ([2] above). Yet 45 percent report having “significant” liquidity.
Question 2. Has your level of liquidity hampered business operations any time during your firm’s growth? If yes, in what way?
Question 3. Was there any particular reason that your cash position has been unusually good or poor in the past few years–purchase of a building or a large drop in sales or profitability for instance?
II. Profitability
Question 4. Subjective rating of profits. What has your profit picture been like for each of the past five years? Rate your firm for each year separately:
Continue reading FINANCIAL VIABILITY: Your Yardstick for Organization Achievement, Part 1

Negotiating Your Way to a Great Deal

Mr. Richard Parker is the author of the “How To Buy A Good Business At A Great Price” series which is sold in over 80 countries. He is the founder of Diomo  Corporation and has personally purchased eleven businesses. Learn more  about Richard and his materials at (

When it comes to buying a business for sale, the most exciting and anxious moments can be experienced when the time arrives for you to enter into negotiations and make an offer. This part of the process completely handcuffs some individuals. There’s really no need for this to happen. Just like every other aspect to the buying process, your preparation will determine your level of success.

Keep in mind that this should be an enjoyable and educational part of buying a business. There is much to be learned during this phase. You must also realize that negotiations will evolve, and so if you approach it with an open-minded strategy instead of a “take it or leave it” philosophy, you will ultimately perform much better and produce a stronger deal.

Likewise, you should also know this is the stage when many deals come apart and never recover. Most of the time this happens because of the inability of one or both parties to truly understand what it takes to get the other side to see their point. Or, a failure to address the other party’s needs in a way that protects your specific interests at the same time.

Negotiating involves many independent personality issues. When dealing with a seller you must bear in mind that this is a very emotional time for them. They are looking to sell a business that has benefited from their hard work and sweat. It can be quite a personal adjustment for many and they do become irrational. They often feel as though they are losing a part of themselves. Be sensitive to their emotions but never at the expense of fabricating a good deal for you.

Your personality traits will come to light as well. Do your best to understand yourself. If for example, you’re not a patient individual, then you must train yourself to avoid giving in on a certain point simply because you’re tired of discussing it. You’re better off to move on to something else and come back to it with the seller.

Find Their “Pain”, Soothe It and YOU Win!

Everybody has their “hot buttons” in a deal. These are the points that, in the mind of the buyer or seller, will make or break the deal. Once you identify them and can find a way to ease their concerns, you’ll win. It works all the time. As an example, if the seller wants to be certain that they walk away from the deal with a specific amount of money in their pocket after broker commissions, paying debt, etc., then the down payment amount of the deal is clearly their “hot button”. There are two ways to determine this: put in an offer and see where and how they counter, or ask them pointedly: “What’s more important to you, the down payment amount or the purchase price.

The former method is usually more effective only because you can read into a variety of issues once you see the structure of a counter-offer. However, asking them directly is a very accurate way to measure this as well.

Getting back to our example, if it’s the down payment then it’s your turn to leverage the deal. Get as close as you can to their figure but, in exchange, get reduced interest rates on the balance of sale, extend the first payment to 60, 90 or 180 days after closing, negotiate the first year without interest, include the ability to payoff the note at anytime without penalty or to make periodic lump-sum payments towards the principal. There are tons that you can do once you know their pain.

An associate of mine who is an excellent negotiator always says that you should make, and get, concessions. In other words, whenever you agree to something, get something in return. It always works.

Preparation is The Key To Successful Negotiating

The average purchase agreement has over fifty individual clauses to be negotiated. There is far more involved than simply agreeing upon the price, down payment and terms. You will have to deal with the specific assets to be included, non-compete clauses, lease assignments, inspection period, adjustments, employee issues, liabilities, and on and on it goes.

Think about the specific point to be negotiated, what your position is and what your rebuttal will be to the seller’s comments. Play the “what if” game prior to sitting down to the table.

Play “what if”

Layout the various points, giving consideration to what the short-term and long-term impact will be of your decision. As an example, if you negotiate finance terms with the seller with one lump-sum payment down the road (i.e. a “balloon payment”) you must also consider that the business MUST be able to make that payment at that time. What if there’s a cash crunch? What if you’d like to use the funds for something else at that time? What if…. you want to balance that with a straight-line finance program so that you’ll know what your obligations are every month and you can budget accordingly. Every situation is different, but again, consider the impact for today and down the road.

Structuring The Offer – and Remember, It’s YOUR Offer!

The offer will, in most cases, begin the ball rolling on a potential acquisition. At times, this is the most effective way to gain insight into the guts of the business. You may also be dismayed to learn that you may in fact have to make an offer without all of the data that you would like to have. As an example, you may only gain access to the true financials after an accepted offer has been put forth.

This is fine; no need to panic. You may be asking: “How can I formulate an offer without all of the information?” A good question in theory, but this is not always reality. Consider the fact that sellers may be exposed to a plethora of buyers and, not knowing which ones are serious, they may choose to hold back certain information.

The offer you present is YOUR offer. You should be comfortable tabling any terms that YOU are comfortable with. Whatever the seller is “asking” is simply a guideline. Remember, it’s an “asking price” not a purchase price. On the other hand, don’t be ridiculous. Table something that forms the basis of a future meaningful conversation. Your offer is, to a certain extent, a tool to prod the seller into playing his or her hand. To get them to demonstrate their pain; the areas that are fundamental to the deal – from their perspective.

There’s nothing wrong if they are insulted. They may or may not be, and you can always refine your offer as the case may be. Additionally, a buyer’s value of the business will certainly differ from a seller. That’s where negotiation comes into play. There are no hard rules for what the terms of your offer should be. Each situation is different. While it’s not advisable to make unlimited offers expecting one to catch on, you MUST make offers. Don’t over-engineer each potential acquisition. Once a business is of interest, you’ve done your homework, and you determine that you would, under the right conditions, like to buy the business, then get your offer in.

There are standard offer-to-purchase agreements available to use. Every business broker will have one and so too will most attorneys. The one thing that you want to be certain of is to retain the ability to rescind your offer at your “sole and absolute discretion” if you determine that the business is not what it was represented to be. However, you cannot have an unlimited time frame to do so after acceptance of the offer.

Generally, once an offer is accepted, you will have a certain number of days to perform the financial due diligence (often referred to as the “Inspection Period”). Allow yourself enough time to conduct this. The idea is that you must be able to retract the offer for any reason whatsoever right up to the last day of this due diligence period.

There are some offer contracts that stipulate that you cannot retract your offer and get a refund of your deposit if the financials are within 5% of what has been presented. This is a ridiculous clause. Never agree to it. You must be able to get any monies returned, for any reason, through the due diligence phase. Conversely, if you sign off after the due diligence and then decide thereafter you do not wish to go through with the purchase, the seller is, in all fairness, entitled to your deposit.

Lawyers and Accountants and Others – Everyone has an Opinion

Let’s understand one thing: lawyers cannot negotiate your deal for you. They can certainly help to ensure your protection from potential liabilities but when it comes to negotiating the actual business deal, they are definitely NOT the ones to act on your behalf. I am certain that any attorney reading this column will disagree. That’s OK. However, I have yet to meet more than a handful of attorneys who demonstrated any proficiency whatsoever in the actual art of negotiating the deal points of a small business acquisition. Most have never even bought a business themselves so even though they may have been involved in deals, it’s not the same perspective. You’ll want to hear their point, but their input should be reserved for the areas in which they are experts: the legal aspects of the deal.

As for accountants, they too have their role: the input from a financial point of view and tax consequences. Leverage their expertise as well, but do not let them influence the actual business deal.

The Last Word

Great negotiators are not born; they evolve. Your effectiveness will increase over time. Be creative. Be reasonable. Keep the end result of putting a good deal together in your mind. Don’t lose patience. Don’t be confrontational. If there is tough news to deliver, let your broker do it. After all, you will need the seller to provide you with training.

Learn from each experience. Understand that there will be set backs; work though each. You cannot win every point. It’s a give-and-take. Prioritize. Prepare.
Win/win is not realistic. The objective is clear: you win, the seller is reasonably happy!