Banking and Financial Services Industry

Major Industry Trends

It is already clear that 2008/09 is going to be a year of unprecedented change for the global banking and financial services sector. The global banking crisis first burst into the media spotlight with the announcement by the US bank, Bear Sterns, in June 2007 that two of its more substantial hedge funds (totaling in excess of US$3 billion), both heavily invested in derivative instruments based on the US subprime mortgage market, were failing. From that point onwards, a crisis that had been gestating for around a decade in the banking sectors of the developed economies began to boil over.

The failure of the US investment bank, Lehman Brothers, in September 2008, focused attention on just how intertwined and interconnected debt had become among leading banks. Credit and interbank liquidity froze across the globe. Since then, governments around the world have been bailing out failing banks, and pumping money into the financial system in an effort to “normalize” banking activities, and to prevent a global financial meltdown.

In a report (published in February 2009) setting out a reform agenda for the European financial supervisory system, Jacques de Larosière, the former Banque de France governor (and IMF managing director), estimated the spate of write-offs and write-downs by banks and insurance companies around the world since the crisis began to be worth €1 trillion. His report presents a succinct account of how the global banking crisis came into being. It argues that excessive liquidity and low interest rates were the major underlying factors behind the crisis, but “financial innovation amplified and accelerated the consequences of excess liquidity, and rapid credit expansion.”

Larosière emphasizes that strong macroeconomic growth since the mid-1990s gave an illusion that permanent and sustainable high levels of growth were not only possible, but likely, and this encouraged excessive risk-taking. Innovative financial products, based on asset-backed securities (billion-dollar parcels of residential mortgages), and termed collateralized debt obligations (CDOs), were created by major financial institutions and sold around the world. Banks mispriced the risks they were taking onto their books with these and other products, most notably, credit default swaps (essentially insurance sold by a provider which guaranteed to “make good” a debt, which could be a government debt, or a corporate or financial institution debt), in return for a premium.

Income streams were created for financial institutions, but these carried vast risks that did not appear on the balance sheets of these institutions. Securitization, a well-respected financial technique for dealing with large bundles of debt with associated income streams (repayments by debtors), such as credit card debt or mortgage debt, moved risk off the debt originator’s balance sheets and dispersed it to investors around the world, often to other banks.

Larosière’s analysis, which has been put forward in various ways by many observers, is that although the crisis originated in the US, it is now global, deep, and (by February 2009), quite possibly, worsening.

“Significant global economic damage is occurring, strongly impacting on the cost and availability of credit; household budgets; mortgages; pensions; and big and small company financing, creating far more restricted access to wholesale funding, and now spillovers to the more fragile emerging country economies. The economies of the OECD are shrinking into recession, and unemployment is increasing rapidly,” the Larosière report says.

The importance of the global banking sector to the real economy is being highlighted in the most dramatic way possible. Falls in global stock exchanges from August 2007 to March 2009 have resulted in losses in the value of listed companies amounting to €16 trillion, the report says.

Larosière, in common with other commentators, such as the European Central Bank (ECB), argues that the credit and housing bubbles in the US, and, subsequently, in Europe, were financed by massive capital inflows from emerging economies, such as China. “In this environment of plentiful liquidity and low returns, investors actively sought higher yields and went searching for opportunities. Risk became mispriced. Those originating investment products responded to this by developing more and more innovative and complex instruments designed to offer improved yields, often combined with increased leverage.”

The resulting debt disaster has engulfed banks, frozen lending, and created a deep pool of “toxic assets” on bank books across the developed world. The solution many governments are adopting is both to refinance banks directly, and to create “bad banks” to buy and hold the toxic assets of banks that are judged to have a reasonable chance of survival. There is, however, a massive difficulty concerning the valuation of these complex assets. As John Mauldin, a US investment guru and market commentator, points out, if the assets are valued too cheaply and are sold on to hedge funds, the government is, in effect, handing a windfall to investors. If they are valued too dearly, taxpayers in the countries concerned bear unnecessary losses.

One thing that has already emerged with great clarity from the crisis is that the “high risk, high reward” model of banking, which US investment banks such as Citibank and JP Morgan Chase went in for, is now completely broken. There are no more investment banks—those that did not collapse have changed their status to deposit-taking banks, in order to make themselves eligible for US Federal “bailout” money.

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Market Analysis

The global banking crisis has been so broad and deep that it has virtually eclipsed other trends in banking. However, while some of these trends, such as the move to greater financial innovation, have undoubtedly been negated by the crisis, other trends persist, and will have an impact on the transformed, post-crash, global banking system going forward. These trends are summarized by Deutsche Bank Research, in a report published in April 2008 on the European banking system. They are as follows.

• Consolidation: Merger and acquisition activity has made the large banks even larger, sometimes with dire results for the acquirer. This has been spectacularly demonstrated by the acquisition of ABN AMRO by the Royal Bank of Scotland (RBS)—the acquisition was partially responsible for RBS posting a £23 billion loss, the largest loss in UK corporate history, in February 2009. However, the trend is also creating more “financial conglomerates,” by matching like with unlike. From one perspective, this can be seen as making the acquiring bank more stable, by diversifying its revenue stream. From another perspective, it introduces incoherence and management difficulties that distract the acquirer from what it does well, and launches management into areas that it does not understand. Examples include the acquisition of Bank of Scotland by the Halifax Building Society in the UK in 2001, to create a financial institution known as Halifax Bank of Scotland (HBOS). Subsequently, in September 2008, Lloyds TSB acquired HBOS, after shares in the latter plummeted amid concerns over its future. However, Lloyds TSB then had to be rescued by the UK government. In March 2009, Lloyds TSB announced losses from HBOS of more than £10 billion, and the British government subsequently acquired a majority stake in Lloyds TSB in return for insuring the bank against future losses on £260 billion of toxic loans, 80% of them from the HBOS side of the banking group.

• Internationalization: European and US banks have sought higher growth by expanding outside their national boundaries, with emerging economies a favorite target.

• Greater use of technology and outsourcing of processes: IT has transformed banking processes, and, along with an accelerating use of onshore and offshore outsourcing, has helped to drive down costs, and increase profitability.

• A shift in the balance of power from West to East: The rise up the global rankings of the top Chinese banks has been spectacular, indicating the growing importance of the Asian market. The Deutsche Bank report points out that, “a deepening integration of the world economy and a surge in exports (prior to the crash) caused GDP growth in emerging markets to accelerate from an average of 3.8% from 1989 to 1998, to some 6.5% in the following decade to 2008. The report argues, too, that emerging markets do not suffer, in the main, from the ageing population syndrome of developed markets. The share of the population aged over 59 is expected to climb to 35% in Europe by 2050, compared to 24% in Asia, according to UN estimates. In a report published in January 2008, titled “What’s in store for global banking?” management consultants, McKinsey, argue that banking, as an industry, is essentially a leveraged bet on national GDP growth, so the higher the GDP growth, the more prosperous the banking sector.

• The rise of shariah, or Islamic banking services: The target market for shariah banking services is the world’s 1.6 billion Muslims, representing 25% of the world’s population, and largely concentrated in emerging economies. The sector, just prior to the crash, had an average annual growth rate of 30%, with the expectation that funds under management would reach US$1 trillion by 2010. There are crucial differences between shariah banking and traditional Western banking, the most important of which, probably, is the prohibition on money earning interest. Islamic law, based on the Qur’an, requires effort to be expended if riches are to be gained. Money, in and of itself, is held to have no value, and cannot legitimately create value from itself. Shariah law can be applied to some major forms of traditional finance, including mortgages and leases, but has real problems with structures such as pension annuities, which are fundamentally based on interest on sovereign or corporate debt. Western banks, such as HSBC and others, have shown a strong interest in developing shariah offerings to try to grow market share in this sector.

Regulation Pre and Post the Crash

The integration of European financial markets is a firm EU goal, with the goal of reaching the level of integration achieved in the US under the US Federal Reserve. Prior to the crash, it was thought that Basel II, the second of the Basel accords, as set out by the Basel Committee on Banking Supervision, and embodied in the EU Directive, would provide a global standard for banking regulation.

The Basel Committee has no legislative power; it simply makes recommendations after thorough consultation with the banking industry. However, as its members are senior representatives of bank supervisory authorities, and the central banks of the G10 countries, plus Luxembourg and Spain, its views hold tremendous sway. The committee meets at the Bank of International Settlements (BIS) in Basel, which accounts for the name of the accord.

Basel II sets up rigorous risk and capital management requirements designed to ensure that banks hold sufficient capital reserves to cover the risks that they incur in trading. It uses a “three pillar” concept, based on capital adequacy requirements, usually modeled by the banks themselves (pillar 1), supervisory review (pillar 2), and market discipline (pillar 3). It is generally held that all three pillars failed, for various reasons, in the current crisis.

The Basel Committee has already issued a consultation document designed to bring all the off-balance-sheet vehicles and risks which Basel II failed to capture, back within the modeling regime used by banks to determine capital adequacy. However, while the final shape of banking regulation post the crash is still being worked through, the market in general fully expects banking regulation in future to be much tougher, with the kinds of risks that banks were formerly allowed to run being much more tightly circumscribed. A popular summary of this view is that banks, henceforth, should be seen as a kind of functional, systemically important, low-risk, low-growth utility. Just how well thought through this proposal is remains to be seen. Global merger and acquisition activity requires a rather different model, and where the liquidity is to come from to satisfy the next growth wave, if banks take on the utility model, is presently unclear.

Jacques Larosière’s report argues that one of the failures of the current regulatory model was that, “too much attention was paid to individual banks, and too little to the impact of general developments on sectors or markets as a whole—insufficient attention was given to the liquidity of markets. EU supervisors failed to spot the degree to which a number of EU financial institutions had accumulated—often in off-balance-sheet constructions—exceptionally high exposure to highly complex, later to become illiquid, financial assets.”

All of this was exacerbated in various ways, including by inappropriate reward structures (bonuses), mark-to-market accounting (which many now argue should be suspended in a crisis), and by inadequate cooperation between regulators.

Not surprisingly, Larosière’s recommendations for the future of regulation include building much tighter links between European and other national regulators, including building a proper crisis-management infrastructure, and deepening the EU’s bilateral financial relations with Asia and the US. Bankers and the entire financial services sector, including hedge funds and wealth managers, can expect much tighter regulation going forward.

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