Inputs needed: the design direction

[standardplayer]

How will the Banks and Insurance Companies that start at the beginning of the game work?

Are they going to be private like software and telecom companies where the founder starts out with 100% ownership and excessive amounts of cash? The Software and telecom companies that start at the beginning with that level of ownership and capital is unrealistic and detracts from the fun of this game.

Would prefer that the bank or insurance company founder does not own 100% of the company at the start because like stated above it is unrealistic and not fun.

See this post discussing the issues with the telecom and software starting capital and ownership:
http://www.enlight.com/forum/viewtopic ... 396#p26396

[Sceptic]

You have brought up some very good points.

My recent game was configured to have a very high start-up capital for all the companies. And interestingly I found each time a M&A occurred, a AI company is created with a huge amount of cash and lots of them flows into the market.

Do you have any suggested solution to this dilemma?

What if all the companies would have borrowed start-up capital in the beginning?

[David]

What if all the companies would have borrowed start-up capital in the beginning?

The debt and the interest payment obligations will be too much of a burden to the companies if they are highly leveraged in the beginning.

[lagrelax]

You have brought up some very good points.

My recent game was configured to have a very high start-up capital for all the companies. And interestingly I found each time a M&A occurred, a AI company is created with a huge amount of cash and lots of them flows into the market.

If I remember correctly, this mechanic has been in the game since Capitalism 2. It is for a new AI company to have a real chance of competing with established companies. Imagine the situation where new AI companies start with lower amounts of capital, they will not be able to compete after the game has run for years or tens of years, with all established companies having strong foothold on the market shares. They will inevitably go bankrupt soon after they are founded.

So if we remove this mechanic, while it may look more realistic, it will actually undermine the gameplay balance.

Do you have any suggested solution to this dilemma?

I don't have a solid solution now. Here are some of my thoughts

Set up a sovereign fund reserve at the beginning of the game and let it grow at inflation rate each year, player can decide the initial amount, like (number of companies * start up capital * user preferred ratio). Also the port import is an important source of revenue especially in the early game. But currently that revenue is just going nowhere. Can put that as another source of income to the reserve fund. All newly created company should be funded by the reserve. No company would join when the balance is zero. When the economy is contracting (in consecutive years), some new money can be created in the reserve at the cost of higher inflation

Also the corporate tax can be divided to federal/national tax and local tax, the former goes into the sovereign fund and the latter goes to the city budget. Player can decide the federal tax rate at the beginning and can not be adjusted by mayors. This can create some feedback loop to the game as the more you earned, more potential competitions you would face.

Let me know how you and dev team think. I feel it is worthy a separate thread to discuss more, like how it can interact with the bank DLC.

[buells]

Let's start with banks, specialty finance, etc.

Banks and other lending institutions have two elements that are fundamentally similar to all other enterprises:

• They need to obtain funding

• They need to invest in assets that generate a return greater than their cost of funds

Banks are funded differently from other companies in that they rely to a much greater extent on debt financing, which generally composes 85% or more of their total funding. Additionally, most banks compete with one another to secure the lowest cost funding possible by attracting depositors, who require a much lower return on their assets than investors in a bank's debt or equity. Of course, investment banks do not always enjoy this advantage and may instead rely on wholesale funding in the commercial paper and repo markets to finance their assets.

On the lending side, banks create assets by lending money to businesses and individuals who are contractually obligated to repay the principal and some amount of interest. Some loans carry a fixed interest rate such as most mortgages, some credit cards, and some auto loans. Business loans usually are tied to an index that varies over time such as LIBOR or the prime rate. Banks attempt to underwrite their loan book to manage the risk of credit losses. Credit losses are impacted both by the rate of default and the rate of recovery on the resolution of bad debts (% of principal recouped in bankruptcy, foreclosure, or liquidation). Lending to riskier borrowers is not necessarily a bad strategy for banks, so long as they charge sufficiently high interest rates to cover the credit losses realized.

Given all of the above, the question is what are the elements of the banking system that would be interesting and practical to include in the game. My sense is that these are the elements which are most important to a bank's strategy.

First, banks compete on many of the same factors that other businesses do. Banks can invest in several types of assets and capabilities. In retail banking, key factors are size of branch and ATM network, technology (e.g., who has the best application and website, most effective payment and anti-fraud technology), brand, and product scope (universal banks often have brokerages offering securities trading, wealth management, etc. along with the typical retail banking products of mortgages, home equity loans, savings accounts and credit cards).

The prices of deposits and loans are the interest rate and fee load on each. Banks tend not to compete much on pricing, at least for most products. Instead, they win or lose based on market share, net interest margin, credit losses, and efficiency ratio (OpEx/Revenue).

Here is my proposal for basic retail and commercial banking (as a starting point):

Banks can build branches in each city. Each branch can offer the following products:
- Checking account
- Savings account
- Credit card account
- Mortgage loan
- Auto loan
- Commercial term loan
- Revolving commercial loan

The branch will have 3 types of units: origination, servicing, and advertising. Advertising will work just as it currently does for other industries.

Origination units will have demand driven in the aggregate by the economic cycle and for a particular company by its product rating (like for other products). Origination can be set by product and by city at different risk tolerance and pricing levels (I am thinking via sliders rather than $ or % numbers). For deposit units, you should just have a slider for pricing. Origination unit experience should impact loan quality (marginally) and maximum throughput. The next question is what drives the supply of loans and the bank's demand for deposits. The answer is bank capital. There should be a universal slider for max leverage ratio (maximum assets/equity capital). Loans will not be originated above the level implied by the max ratio until more retained earnings are created or capital is injected from equity raises. Deposits can be generated up to an amount defined by the formula total assets - minimum equity - long term debt = total potential deposits. The difference between total potential deposits and actual deposits is the amount of wholesale funding. Wholesale funding would be more expensive than deposits, but it is not constrained by the bank's ability to generate deposits.

Now, the servicing unit. Once loans or deposits are originated, they accumulate in the linked servicing unit like inventory would. The bankwide balance sheet reflects loans on the asset side of its books and deposits on the liability side. Deposits bear interest to depositors at a floating rate slightly above the nominal risk-free interest rate (with a small premium based on pricing offered). Accumulating deposits is beneficial because they are cheaper than wholesale funding. The deposit accounts should follow a curve where over several years the value for the weighted average account in a given vintage rises (liability increases and the bank's cash increases) and then declines with the length and height of that curve depending on the brand and servicing quality (unit experience level).

For loans, a similar principal curve should be in place. Credit card principal balances would follow a shape similar to deposits. Mortgage loan balances amortize steadily over time (25 years!) Auto loans should amortize steadily over 36 months. Commercial term loans should amortize over 3-5 years. Revolving commercial loan principal should increase in a good or very bad economy and decrease in a bad or recovering economy. Loans will also have a loss curve for each vintage. Losses do not occur immediately but over the course of the loan vintage's life it will lose some % of the then outstanding principal. The credit loss percentage will be based on a confluence of factors (servicing unit experience, loan quality (based on quality at origination... which should be hidden from the user), and economic performance at a point in time). Economic performance can include numerous things which can vary by loan type (change in real interest rate vs. at time of origination, unemployment level, GDP growth, change in real estate prices within city for mortgages). Hearkening back to the origination unit, loan quality is determined by aggressiveness and origination unit experience level. The loan quality of a vintage will be a calculated factor and not apparent to the player. Real life credit loss curves for different loan types are widely available online.

Credit losses will reduce the principal outstanding in a vintage and thus reduce the interest and principal which will ultimately be collected. There is no cash outflow when credit losses occur, but there is a net income hit and commensurate reduction in asset value reflecting the expectation of lower future interest rates. Credit losses reduce equity and thus reduce the maximum assets a bank can hold. If equity declines such that the bank exceeds the player's maximum target leverage ratio, the bank will cease originations until assets and liabilities decline such that the ratio is met. If equity goes negative, the bank is insolvent (at least in accounting terms). It is kind of complicated how to deal with that because insolvency does not cause a bank to shutdown but rather illiquidity does.

There is another risk/reward trade-off we have not yet considered. This is the duration mismatch of assets and liabilities. As we have described, certain loans will have fixed interest rates and some will have floating. Deposits I have described as floating, but we could add fixed rates like CDs. Among the fixed rate products, each will have different maturities creating different durations. Net interest margin will be impacted by the fluctuations in floating interest rates assuming there is some duration mismatch. My suggestion is for deposits and loans to each have their organic weighted durations based on product type. Then the player can try to balance or (further exaggerate) the net duration by issuing fixed rate bonds, equity (gives cushion to absorb any rate volatility), or selling assets.

There should be an analytics dashboard that shows the following for each city and in the aggregate for one's company with graphs over time as well as current month, last month, YTD, and last year info:
- Loan principal outstanding by product type, fixed vs. floating, and aggregate
- Loan interest $ income and rate % by product type, fixed vs. floating, and aggregate
- Loan credit losses by product type, fixed vs. floating, and aggregate
- Deposit principal outstanding by product type, fixed vs. floating, and aggregate
- Deposit interest $ income and rate % by product type, fixed vs. floating, and aggregate

Basically the strategic idea is that if you take more interest rate risk by having a heavily fixed rate portfolio, you can make more money or get burned depending on where interest rates go.

Banks should be able to invest in other assets as well including government bonds, government bills, mortgage backed securities, and corporate bonds. Banks should be able to sell these assets as needed.

The income statement should look something like this:

Interest Income
Less: Interest Expense
= Net Interest Revenue

Less: Credit Losses
= Net Credit Revenue

Less: Marketing Expense
Less: R&D Expense
Less: Origination Expenses
Less: Servicing Expenses
(Combined equal OpEx)
= Net Income

KPIs would be:

Leverage Ratio = Assets/Equity
ROE=Net Income/Equity
Efficiency Ratio=OpEx/Revenue
Interest Yield=Interest Income/Loans+Bonds
Net Interest Margin=Net Interest Revenue/Interest Income
Net Credit Yield=Net Credit Revenue/Loans+Bonds
Fixed and Floating % of Total Loans+Securities
Weighted average age of deposits (by type)
Weighted average age of loans (by type)
% of Funding from Deposits
% of Funding from Wholesale funding

My view is fixed operating costs should be fairly high relative to variable operating costs. Most banks have significant operating leverage. There are many more aspects of the banking system that could be profitably added, but this seems to me like a good start.

[leatra]

I like most of the ideas presented here. I think the Digital Age DLC was a good precedent of how a business-focused DLC should be for Capitalism Lab (my favorite is still the city DLC though) so that can be used as an example for design direction.

[David]

Let's start with banks, specialty finance, etc.

Banks and other lending institutions have two elements that are fundamentally similar to all other enterprises:
They need to obtain funding
They need to invest in assets that generate a return greater than their cost of funds

Thanks for your inputs. I've forwarded them to the dev team.

[buells]

Thanks, the above is probably over-complicated, upon reflection. There is a book I would recommend on banks called The Bank Investor's Handbook (free on kindle unlimited) that explains bank concepts really clearly and simply.

To simplify what I said in my previous post, I think the parts of bank strategy that might be the most important to simulate are:

- Branch network (increase your fixed costs and investment to increase loan and deposit growth)
- Credit risk (again, fast loan growth comes at a price of greater exposure to economic cycle)
- Funding costs (having lots of organic deposits enhances net interest margin; high leverage is likewise good until it isn't)
- Different types of banks/banking relationships (business lending, consumer credit, mortgage lending, asset based lending... diversification reduces risk and lets you spread costs if you can hit efficient scale in each mkt)
- Technology (maybe a combo with Digital DLC... mobile banking has become very important where the company with the best apps wins)

I think capturing those factors can be done in many different ways, and part of it may just be a matter of having sliders, etc. I think the level of complexity would probably best match Software/Internet Cos. as opposed to media/telecom. I find the former a lot more interesting to play around with than the latter.

[David]

To simplify what I said in my previous post, I think the parts of bank strategy that might be the most important to simulate are:

- Branch network (increase your fixed costs and investment to increase loan and deposit growth)
- Credit risk (again, fast loan growth comes at a price of greater exposure to economic cycle)
- Funding costs (having lots of organic deposits enhances net interest margin; high leverage is likewise good until it isn't)
- Different types of banks/banking relationships (business lending, consumer credit, mortgage lending, asset based lending... diversification reduces risk and lets you spread costs if you can hit efficient scale in each mkt)
- Technology (maybe a combo with Digital DLC... mobile banking has become very important where the company with the best apps wins)

Thanks for your suggestions. I have forwarded them to the dev team.

My understanding is that the following are somewhat simulated in the current implementation, as stated on https://www.capitalismlab.com/banking_dlc/

- Branch network (increase your fixed costs and investment to increase loan and deposit growth)
- Credit risk (again, fast loan growth comes at a price of greater exposure to economic cycle)
- Funding costs (having lots of organic deposits enhances net interest margin; high leverage is likewise good until it isn't)

Do you have more concrete ideas about how this should be implemented?

- Technology (maybe a combo with Digital DLC... mobile banking has become very important where the company with the best apps wins)

[buells]

The simple approach would be just to have some technology that can be researched that increase the "quality" of bank products for consumers.

Alternatively, there can be an internet company type set-up whereby you can develop a mobile banking app that would kind of be the equivalent of Ecommerce? That would only be available if you have both DLCs.