Elnamaki A New Landscape May09[1]

global economy

may 2009

www.capital-me.com

By Dr. M S S El Namaki

A New

Landscape Banking After the Credit Crisis

A myriad of reasons have been given for the current credit crisis and the ensuing dramatic economic episode. Practices within the investment banking industry, lax government regulation, creative finance, bad monetary policies and irresponsible executives are all pointed out as culprits. Culture, ideology and the sheer desire to amass wealth are also added. In the end, greed has been identified as the underlying common denominator and the force that transcended functions, structures and people.

T

he question on everybody’s mind today is how long it will all last and what will emerge from this virulent force of nature.

Roots of Crisis The crisis can basically be attributed to three triggers: faulty financial instruments, bad institutional framework and aberrant strategies. Instruments One of the prime instruments involved in the ongoing crisis is securitization. It was the pivot in credit volume expansion and credit risk enhancement. It is a form of structured finance whereby financial assets, especially those for which there is no ready secondary market, such as mortgages, credit card receivables and student loans, are pooled and used as collateral for new securities. Securitization, through highly rated mortgage backed securities (MBSs), allowed mortgages with a high risk of default to be originated almost at will, with the risk shifted from the mortgage issuer to investors at large. Securitization also meant that issuers could repeatedly relend a given sum, greatly increasing their fee income and dodging default risk. Investment banks assumed a key role in securitization. Institutions A shadow banking system devoid of regulation disregarded common sense and assumed a high risk mantel. Investment banks, as the prime players within the shadow banking system, went into massive debt and invested the proceeds into MBSs, essentially betting that house prices would continue to rise and that households would continue to make their mortgage payments. What they did was borrow at lower interest rates and invest the proceeds at high48

One of the prime mistakes made by contemporary bank management is focus on current revenue and making that the base for mobility and rewards.

er interest rates, or practice financial leverage. This is a strategy that would work under normal market conditions or conditions where real estate prices assume a stable upward trend. The opposite occurred. Result: mortgage default and collapse in the value of MBSs. Losses in MBSs among investment banks resulted in a decline in their operating capital and a loss of confidence of creditors. Three investment banks collapsed: Bear Stearns, Lehman Brothers and Merrill Lynch. Strategies Speculative leverage had become a mainstream strategy for banking and insurance institutions, with speculation and greed replacing sound business strategies and becoming the prime force within financial markets. Three types of borrowers contributed directly towards the accumulation of insolvent debt: The hedge borrower who expected to make debt payments from cash flows from other investments; the speculative borrower who borrowed believing that the appreciation of the value of the assets would be sufficient to refinance or pay off their debt and who did not have sufficient resources to repay the original loan; and the Ponzi borrower who relied on continually rolling over the principal into new investments. Speculation reached epidemic levels in the U.S. The End of the Tunnel The following table projects forecasted values for GDP growth, unemployment, consumption expenditure, investment expenditure and current account balance for a few key economies and two crucial years: 2010. The countries and areas involved are the U.S., the EU, Japan and China. 49

global economy

may 2009

www.capital-me.com

Table (1): Key economic projections for the U.S., EU, Japan and China for the year 2010; the official view. Growth indicators GDP growth percentage Unemployment Real gross fixed capital formation percentage change from last year Current account balance percentage GDP Actual vs. potential GDP

USA 0.0 * 10.3*

2010 EU Japan -0.3* -0.5* 11.7* 5.6*

-3.3*

-2.1*

-1.9*

43%****

-3.6** -8.8*

-1.1** -7.2*

3.9 -9.6*

10.0 *** n/a

China 8.5***

by a pool of talent that they have managed to assemble from the leftovers of the U.S. carnage. The independence of American investment banks today is in doubt; reasons start with the risk of insolvency. Investment banks have higher leverage than other banks (in America, at least), which worsens the impact of falling asset values. They also lack the stable earnings streams of commercial and retail banking. When the market for structured finance revives, it will be smaller and less rewarding than before, and investment banks will learn to orient towards their prime core competencies, i.e., corporate finance, advisory, brokerage and asset management.

Sources: (*) OECD March 2009 projection. (**) IMF in constant 2007 dollars. Estimates were made before the credit crisis. (***) Rate oscillates almost daily. These figures were given by the Chinese government in late March 2009. **** Estimate.

It does not take much analysis to conclude that the outlook is dark and economic contraction is a common denominator for the U.S., Japan and the EU. The most striking figures are those of actual vs. potential GDP, where the figures vary only slightly between the three countries and reflect a failure to exploit the resource base of those countries. China, in contrast, comes out quite well in terms of growth levels and expectations. The Future of Investment Banking The U.S. investment banking industry will experience dramatic contraction and new entrants − possibly from the Gulf and China − will assume a key global role. The industry will also be regulated. U.S. investment banks have depended heavily on short-term funding and high leverage to generate exceptional return on equity. Good times proved them right, but bad times, compounded by poor risk management, judgment and decision making, spelled disaster. The future will see far-reaching change in both the function of and participants in investment banking in the U.S. and, most likely, Europe. The function will continue, be it in a modified scale and form. There are no major, independent investment banks left in the U.S. today and the future carries low probability of the emergence of as strong or powerful players as those that once existed. Novel entrants from places like China and the Gulf States will emerge. Their entry will be assisted 50

The Future of Private Equity and Hedge Funds. Private equity is dependent on leverage and attractive deals and both are under pressure in the current environment. The future will only bring an escalation of this situation. And regulation may not be far off. Private equity was, for some time, in fashion. The principle of opportunistic leveraged buyout of businesses and rapid and enhanced sale of restructured and presumably healthy companies caught fire. Funds saw massive growth in number, volume, size and coverage and the figures were staggering at times. Participation in private equity activities was widespread, with the U.S. heading the list. Buying companies with the help of masses of debt made the private equity industry particularly vulnerable to both credit shortage and the declining value of its portfolios. The argument that leverage enhances returns to shareholders proved false. Private equity firms, as a whole and over a period of three decades, achieved an average annual return equal to or less than that of Standard & Poor’s 500stock index. The industry is very likely to witness fund withdrawal as well as rigorous regulation The Future of Universal Banking Universal banking will expand, first as an escape mechanism for investment banks and second as a safer, more manageable version. The U.S. 1933 Glass-Seagull act, which separated investment banks and commercial banks, was repealed in 1999. Universal banks, which marry investment banking and deposit taking, will ascend. For regulators, larger, diversified institutions are more stable than investment banks. The risks are lower, but it goes without saying that they do not go away. And deposit funding is cheaper than wholesale funding in part because those deposits are insured. For shareholders, too, the universal bank may offer comfort.

The Future of Central Banking Central banks will resort to new vehicles to stimulate liquidity and credit. These will rely on direct-to-market transfers. Central banks’ practice of regulating economic activity by adjusting the level of the interest rate may not always work, as witnessed in Britain in recent months. The limit is the level of this interest rate. Once the base rate gets close to zero, that approach no longer works. Quantitative easing measures are a new approach undertaken by the Bank of England in order to raise the monetary base or cash and commercial bank reserves. Quantitative easing is unchartered territory. The Bank of England will buy government securities as well as private assets such as commercial papers, to the tune of $105 billion, and will pay for this with its own money (contrary to the practice of financing transactions by the issue of Treasury bills). The measure would stimulate cash flow, as the Bank of England would pay for the purchases by crediting the accounts of commercial banks, but it is basically creating money. And inflationary fears may be a faint step away.

The Future of Hedge Funds The American hedge fund industry will seriously suffer from massive investor redemptions. Regulation may be on the horizon. Steep losses and a series of high-profile collapses put American hedge funds at the heart of the credit crisis, forcing hedge funds to reconsider operations and take on a more defensive profile. U.S. institutional investors have been withdrawing funds from hedge funds to meet commitments to private equity, although private equity portfolios are not performing that much better. The migration of disillusioned investors has reached critical levels, with an outflow of $152 billion in the fourth quarter of 2008 reducing total industry assets to $ 1.4 trillion at the end of 2008. The Madoff affair also simulated redemption. Current estimates put industry holdings at less than $ 1 trillion, compared with $ 2.7 trillion in June 2008. Further decline in fund holdings may lead to a decline in total industry holdings to $ 950 billion. It is striking that investors who tried to redeem their funds late in 2008 found that their hedge fund investors had temporarily limited or barred exit. The Future of Bank Management Banks will be managed differently, with greater emphasis on long-term returns instead of short-term revenues. One of the prime mistakes made by contemporary bank management is focus on current revenue and making that the base for mobility and rewards. Although longer-term profits may never have materialized, short-term revenue-rooted rewards were granted. Change is taking place and in several directions. First, banks are told by governments that profits matter more than revenues. Put differently, executive performance should be measured by profit realization over a given period rather than instantaneous book revenue generated at the moment of the transaction. Banks are also told compensation should be based on a return on equity over a justified period of time, not current year revenue. In the process, banks are learning that true chemistry should provide a decision base, i.e., leverage works when the curve is upwards and does not work, to a disastrous extent, when the curve is downwards. Also, diversified and recurring revenue streams work wonders when the tide is down. And, finally, risk management should become a board responsibility. Lower-level risk taking could jeopardize the entire organization.

The U.S. investment banking industry will experience dramatic contraction and new entrants − possibly from the Gulf and China − will assume a key global role.

Dr. M S S El Namaki teaches and consults on strategic thinking, entrepreneurship and international business. He is past founder and dean of the Maastricht School of Management, Maastricht, The Netherlands (19842002). El Namaki has developed and introduced management degree programs into no fewer than 25 countries, including the Netherlands, China, Egypt, Brazil, Poland, Canada and Indonesia. He has held executive positions with Philips (Eindhoven), McKinsey (London and Dar es Salaam) and Time Inc. (Amsterdam). El Namaki’s book Strategy and Entrepreneurship in Arab Countries was published last year. 51