The dramatic actions in the last few days of the European and American central banks and treasuries suggest the beginning of the end of the global debt crisis. Some of them, especially the partial nationalization of national banking systems and the unlimited government guarantees of financial contracts, are unprecedented in modern finance. More surprises are probably still to come. But it is not too early to think about what kind of global financial architecture will emerge after the dust settles – and what impact this may have on some of the key banks and financial centers. The basic functions of global banking and finance will continue, or course, but they are unlikely to return to business as usual anytime soon.
The leaders of the global wholesale banking business have suffered greatly during the gales that have been blowing though financial markets for months: In the US, Lehman Brothers and Bear Stearns have disappeared into Barclays, Nomura and JP Morgan Chase; Merrill Lynch was forced into an unwanted merge;, Citigroup is on the ropes while Morgan Stanley and Goldman Sachs have suddenly turned themselves into bank holding companies and raised new capital to weather the storm. Now the US Treasury will buy equity stakes in all of them to bolster their capital whether they like it or not – and with the use of taxpayer money will inevitably come some basic changes in business strategies and market practices.
Their European counterparts have been ravaged as well. Fortis, trying to stabilize after last year’s indigestible takeover of ABN-Amro, has collapsed. UBS has been rescued in a massive bail-out by the Swiss government and Credit Suisse has been forced to raise additional capital. UniCredit seems shaky despite Italy’s assertion that all is well. The British government has had to take over Royal Bank of Scotland and HBOS, and to recapitalize Lloyds TSB. After an last-minute effort to coordinate policies, a more systematic EU approach has evolved, centered on some sensible principles, which likewise involve significant government ownership stakes in banks until the emergency has passed.
It is hard to say at this time who the leading banks will be in the global financial marketplace that will emerge after the present storm has passed. Most likely the same ten firms (two of them Swiss) that accounted for about 80% of transactions before will, in whatever new configuration they may appear in, should continue to lead the industry – at least for a while until changes in the regulatory and competitive environment take hold. All of these firms, however, are now large, complex universal banks or financial conglomerates that have been classified as too-big-to-fail. One thing that seems quite sure is that these firms will be subject to greater regulatory control than before.
Looking ahead, three issues come to mind in trying to define the future architecture of global finance:
First: Is this the end of aggressive “Americanized Finance?” Probably not. The strongest American firms are still there and two in particular, Morgan Stanley and Goldman Sachs (both with more than half of their revenues outside the US) are among the industry’s most international firms, doing business locally all over the world. For them, the capital markets of the world after the crisis will be fully integrated and available to corporations, governments and global investors. Each is now a bank holding company, and ought to be able to resume leadership roles in global finance once the storm has passed. Together with Citigroup, Bank of America – Merrill Lynch and JP Morgan Chase they will comprise perhaps half of the global players, in each case after some major organizational and strategic changes likely to get underway shortly.
Second: Does the current turbulence vindicate Europe’s belief in the supremacy of the universal banking model over all other forms of financial organization? Again, probably not. Universal banks in Europe and the US have been no better than the so-called “stand-alone investment banks” in their ability to avoid the leveraged exposures to toxic assets or to maneuver adroitly to avoid trouble – nor have they found a better way to provide adequate and durable investment returns for their stockholders. If the data are to be believed, some 42% of impaired US mortgage-related debt now rests on the balance sheets of European banks and investors. The universal banking debate is likely to continue for some time, but the pressure today seems to be for a number of leading universal banks to dispose of their hard-to-manage investment banking units. And there is plenty of evidence that financial conglomerates fare no better than industrial conglomerates in how investors value their shares. So perhaps the current shift to the universal banking model is not the end of the story.
Third, how could so much systemic damage occur in an Industry that has been diligently regulated for decades? What happened to the Basel minimum risk-adjusted bank capital adequacy regime? The storm was one that destroyed liquidity under massively leveraged conditions rather than one that caused damage from credit defaults. The Basel approach does not regulate liquidity. It turns out that even the most adroit credit risk modeling, in full compliance with national and international banking regulations, completely missed the source of a risk domain that has threatened the integrity of the banking system.
In the near future bank regulators will have to agree that a couple of aggregate ratios are not enough to provide adequate safety and soundness of individual institutions or of the banking system. They will have to have the power to slow down excessively rapid financial growth, disallow excessive leverage and trading exposures, and in general treat the leading banks more as providers of essential economic services such as those provided by public utilities.
The riskier and more aggressive activities in the market – still welcome – may well be provided by smaller organizations – perhaps a new generation of investment banks alongside more transparent hedge funds and private equity firms – with less leverage and less capacity to injure the entire system if they fail. This could result in the largest banks, whether American or European, universal or stand-alone, deciding not to continue giant institutions with many of the characteristics of public utilities, but rather to break themselves up into less regulated and more agile units. Investors in the financial industry could then decide how to deploy their capital among firms with very different growth prospects and risk exposures. Caveat emptor would still apply, but the core functions of banking and securities markets would not be as vulnerable as they have turned out to be this time.
We think it is too early for the surviving large banks to congratulate themselves on the prospects for taking up the market shares left behind by the departed. The next evolution will be the strategic repositioning that firms will make to adjust to the regulatory changes that will be forthcoming: Some will perhaps chose to break themselves up into smaller, more manageable and less regulated parts. Some will p[refer to occupy the leadership slots in the industry while reducing their risk exposures and perhaps their ROIs and growth potential. But there will be changes. Modern capitalism is very adaptive and very much a process of creative destruction.
Originally published at Stern on Finance on Oct 22, 2008 and reproduced here with the author’s permission.