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Bonds Are Not Forever: The Crisis Facing Fixed Income Investors by Simon A. Lack

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CHAPTER 5

TRADING DERIVATIVES

Before Banks Were Exciting

Banking was a pretty boring business for most of the twentieth century. Taking deposits and lending them to earn a spread isn’t exciting, and there’s a strong case that banking should be boring. My grandfather worked for the National Provincial Bank (a predecessor to NatWest) until he retired in the 1970s, and growing up I developed the strong impression that banking was a pretty serious, stodgy business (although my grandfather, when he wasn’t in his bank manager role, was anything but).

Innovation began to creep into banking in the late 1970s/early 1980s, just as the big bull markets in stocks and bonds were beginning and the securities industry was at the start of almost three decades of steady growth. While there were many factors at play that caused this, the development of the personal computer must rank up there as one of the most significant.

Banks handle large amounts of data, and the ability to perform analysis across hundreds or thousands of borrowers and account holders added a completely new dimension to risk management. The development of credit cards provides a great example. Conventional loan assessment required a detailed analysis of the borrower’s financial situation, ability to pay, sources of income, and assets. The objective of every bank was to avoid making any loan that would not be repaid. Bankers have always recognized that default was a risk and that surprises happen, but the basic method of approving ...

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