Now that the global debt crisis has destroyed many of the more respected and venerable institutions on Wall Street, and has caused more damage and dislocation to the wholesale financing industry than anything experienced in seventy-five years, the question is “what next?”. Lehman Brothers and Bear Stearns have disappeared, Merrill Lynch and Wachovia were forced into unwanted mergers, Citigroup is gasping for new capital and Morgan Stanley and Goldman Sachs have suddenly turned themselves into bank holding companies and raised new capital to weather the storm. The US Treasury has proposed buying equity in banks to bolster their capital. More surprises may yet happen before it is all over.
The storm turbulence has ravaged European banks as well. Many of the Europe-based global firms such as UBS, HSBC, RBS and Barclays have also suffered huge mortgage-related write offs, management changes or reorganizations. Fortis, trying to stabilize after last year’s indigestible takeover of ABN-Amro, has collapsed, Dexia has been rescued by France and Belgium and Unicredit is wavering – even as the German government sets about the messy bailout of Hypo Real Estate Holding AG in a $75 billion joint effort with the country’s banks. European governments are being forced to rescue their own banks without much coordination, while the ECB pumps liquidity into the system as fast as it can top keep the damage from spreading. Like the US, the UK is injecting equity capital into its banks to kick-start credit in the economy and restore interbank lending.
To be sure, many of the world’s top ten wholesale banks have struggled through this period with only their stock prices in disarray. Deutsche Bank, Credit Suisse, BNP Paribas, JP Morgan Chase, Bank of America, Morgan Stanley and Goldman Sachs have come through the crisis so far relatively unscathed. But so many other banks have been irreparably damaged as to raise new questions about the future of the industry.
Three questions seem especially on the minds of European financial industry participants and their regulators at the moment.
First: Is this the end of aggressive “Americanized Finance?” Probably not. The strongest American firms are still here, and two in particular, Morgan Stanley and Goldman Sachs – with more than half of their revenues from 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 are fully integrated and increasing available to corporations and governments as they have never been before. They are now bank holding companies, and ought to be able to resume leadership roles in global finance once the storm has passed.
Second: Does the current turbulence vindicate Europe’s belief in the supremacy of the universal banking model over all other forms? Again, probably not. Universal banks have been no better than the so-called stand-alone investment banks in their ability to avoid the leveraged exposures to toxic assets or maneuver adroitly to avoid trouble, nor have they found a better way to provide adequate 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 on 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.
Third, how could so much systemic damage occur to an Industry that has been diligently regulated for 20 decades? What happened to the Basel minimum risk-adjusted bank capital adequacy regime? The storm was one that destroyed liquidity rather than one that caused damage from credit defaults, and the Basel approach does not regulate liquidity. It turns out that even the most adroit credit risk modeling, in full compliance with banking regulations, completely missed the source of a risk domain that now threatens the integrity of the banking system.
In the near future the leading central banks of the world will have to reconsider Basel 2, and agree that a couple of aggregate ratios are not enough to provide adequate safety and soundness of individual institutions or of the banking system. Bank regulators will have to have the power to slow down excessively rapid financial growth, disallow excessive 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 – should be provided by smaller organizations – perhaps a new generation of investment banks alongside more transparent hedge funds and private equity firms – with 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 units. Investors in the financial industry could then decide how to deploy their assets 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.
In any event, it is too early for the surviving large European universal banks to congratulate themselves on the prospects for taking up the market shares left behind by the departed and wounded Americans. Some have left the battlefield and perhaps others may follow, but the investment bankers will soon have repositioned themselves at other addresses. Modern capitalism is very much a process of creative destruction. The game will go one with players in different uniforms even as the inevitable changes in the regulatory system, as yet unclear, will produce further changes down the road.