A new financial era begins

A new financial era begins According to Mark Giff


The crisis is still far from over, and just when we think we understand it, another surprise pops up. Nevertheless, there is broad agreement on at least some of the causes, and the responses to these will help define the future shape of the financial world. ING chief economist Mark Cliffe gives his view on how the new financial landscape might look.

Here are twelve themes that may drive the process:

1. Tomorrow’s rules won’t be the same as today’s
2. The law of unintended consequences
3. Back to basics
4. The market isn’t always right
5. The age of frugality
6. Trust will need to be rebuilt
7. Keep it simple
8. Government will have a bigger say
9. Central banks will pay more attention to asset prices
10. From globalisation to localisation
11. A more competitive financial eco-system
12. The cycle still exists… there will be an upswing

1. Tomorrow’s rules won’t be the same as today’s

The crisis has wrong-footed observers repeatedly. This should make us wary of firm predictions of the new financial world. This sense of humility is reinforced by the realisation that the full extent of the damage caused by the crisis has not yet been realised. Thus the current tally of losses incurred by banks worldwide is around US 700bn, but the final bill could be a mutiple. As a result, the rules of the game may change several times before the picture becomes clear.
2. The law of unintended consequences

The law of unintended consequences has been at work in spectacular fashion in this crisis. Just one example should suffice: the previous celebration of the efficiency gains from the risk-spreading arising from the global distribution of structured credit instruments has given way to an awful realisation that the risks were concealed, and through the application of leverage, effectively multiplied in the process. Sadly, the law of unintended consequences will continue to apply. The severity of the economic downturn sparked by the turmoil will make everyone determined to avoid a repeat. The hope is that the prospect of a more conservative and robust financial system will revive confidence. But the danger is that same prospect will make lenders and borrowers even more cautious in the short term, complicating efforts to revive the global economy. Thus banks, under pressure to raise their capital adequacy ratios to more ‘prudent’ levels in the face of a recession, will find it harder to step up their lending.
3. Back to basics

Some of tomorrow’s rules may look rather like yesterday’s. Now that the credit boom has turned to bust, the financial sector is reverting to more traditional conservative practices. High returns from investment banks and hedge funds turn out to have been based on high levels of borrowing; they have been brought down to earth, in some cases with a crash. Suddenly, conservatively run banks with diversified sources of funding and large pools of retail savings are looking smart. The outsourcing of risk evaluation to the now embattled credit ratings agencies has given way to the idea that in-house credit skills are to be prized. Lending multiples have been reduced, and the cost of loans has risen to better reflect their risks. Even if these trends start to reverse in the next economic upswing, the reversal will be more cautious than it was in the past. If the price of this is a slower recovery, it is widely seen as a price worth paying for more stable and sustainable growth.
4. The market isn’t always right

The credit boom was based on the belief that risks could be sliced, diced and priced efficiently by the financial markets. Fair value accounting was founded on the notion that market prices are the best measure of ‘value’. Banks started to rely on the wholesale money markets, believing that they would always be a liquid source of funds. These beliefs have been shaken by the crisis, which revealed that the financial markets fell well short of the perfection of the economics textbooks. When it came to the crunch, they lacked the large numbers of fully informed buyers and sellers required to produce viable prices and continuous trading. Some financial markets, old as well as new, simply shut down as a cloud of uncertainty over the scale and location of losses descended on the financial sector. Crucially, this led to a collapse in lending between, and to, banks. This massive market failure will have to be addressed in the new financial world. Transparent securities on open exchanges will be essential to the creation of liquid markets.
5. The age of frugality

Those who borrowed excessively are going through a painful learning experience. Some have been bankrupted as falling asset prices have combined with rising borrowing costs. Even those who escaped this fate will heed the lesson. In countries like the US and the UK, where consumers borrowed heavily to fuel their spending, thrift will become fashionable. More expensive credit and the wealth losses that consumers have suffered will stimulate a rebuilding of savings. For their part, the banks, having discovered that the money markets can be a fickle source of funds, will be keen to cultivate retail savers by offering attractive interest rates and services.
6. Trust will need to be rebuilt

A collapse in trust in – and between – financial institutions has been both a cause and a consequence of the crisis. Confidence in the industry will need to be rebuilt, especially in markets where banks have failed. Financial institutions will have to show that they are worthy of consumers’ trust and respect. Clarity about their financial strength, business models and products will be essential. Consumers, having had their fingers burnt with unexpectedly risky products or excessive leverage, will want to avoid a repeat. Transparency will also be required for a revival in trust, and trading, between financial institutions.
7. Keep it simple

Complexity has been another casualty of the crisis. Many investors, both individual and institutional, clearly did not understand the risks that the new financial markets were exposing them to. Indeed, even the banks and the issuers of many derivative based securities failed to understand the complexity of the risks that they were running. So aside from transparency, simplicity will be appealing. This will lead to efforts to standardise products, which will have the incidental advantage of making them easier to trade. Consumers will demand easily understandable information about what they are buying. It will be all the more important for financial institutions to think from the customer’s point of view.
8. Government will have a bigger say

The financial crisis is forcing governments to step in. With private savers looking to rebuild their battered savings, governments are trying to support economic activity through tax cuts or extra public spending. So public borrowing is replacing private borrowing, and government will play a bigger role in the economy. The crisis has also obliged governments to support the financial sector itself. Capital injections and even outright nationalisation of financial institutions means that taxpayers’ money is now on the line. Despite popular anger, most governments claim that they do not wish to interfere in commercial decisions and that their intervention will be temporary. However, the depth of the crisis is such that this involvement could last several years. Meanwhile, there will be lasting changes to regulation. The systemic nature of the crisis has revealed glaring gaps in international and domestic regulation. Tougher rules on capital adequacy and liquidity ratios are inevitable. There will also be determined efforts to improve market functioning through improved disclosure and transparency. Consumers can also expect greater protection, beginning with the US mortgage market, where the crisis began.
9. Central banks will pay more attention to asset prices

Critics have accused the central banks, notably the US Federal Reserve, of adopting an asymmetric approach: tolerating booming asset prices and then easing monetary policy aggressively when they subsequently plunge. They argue that this contributed to recent bubbles by encouraging excessive risk-taking. It seems likely that central banks will be more inclined to clamp down on strongly-rising asset prices in the future. This means that interest rates may be raised at an earlier stage in the next cycle, which may dampen down the economic upswing.
10. From globalisation to localisation

It is said that ‘economics is global and politics is local’. The politicisation of the crisis has raised real questions about the sustainability of globalisation. Why should taxpayers bail out foreigners? This question has complicated efforts to resolve the crisis. The rebuilding of trust and regulation, along with government intervention, will inevitably start at the national rather than the global level. Global financial institutions may be forced to embrace ‘multi-local’ business models to thrive in this new world.

The shift towards self-reliance may prompt a global rebalancing of saving and investment flows. Government policy will look to reduce dependence on foreign capital. Debtor nations, led by the US, are likely to increase their domestic savings. The flipside of this is that creditor nations, led by China, will find it tougher to pursue export-led growth and will therefore have to boost domestic spending. Now that ‘cash is king’ and creditors royalty, this will accelerate the rebalancing of economic and financial power towards the East.
11. A more competitive financial eco-system

The crisis is transforming the financial services industry. Collapsing asset prices and savage deleveraging has put paid to the heavily-leveraged business models of the US investment banks and many players in the so-called ‘shadow banking system’. Smaller and more conservative financial institutions that avoided the toxic complexities exposed by the crisis will probably continue to thrive, but bigger institutions may face more aggressive restructuring. Marriages forced by the crisis may lead to some complex divorces once regulators refocus on competition concerns. Global financial institutions will certainly face intense scrutiny, requiring clarity in their business models to justify their existence to regulators, investors and customers. There will be no quick return to the long boom in financial sector profitability that has been running for the last 30 years. Even once the current recession has ended, structural changes will weigh on the industry’s profitability. These include lower leverage, tougher regulations and possible extended state involvement, as well as margin pressures from product standardisation.
12. The cycle still exists… there will be an upswing

Not so long ago there was still talk of a ‘super-cycle’, despite the evident distress in the developed world. Subsequent events have shown that even super-cycles are prone to busts. Nevertheless, aggressive policy responses should reassure us that another Great Depression is not in the offing and that a recovery will ultimately emerge. Indeed, the crisis presents some tremendous opportunities as asset prices are driven down to below depression levels. Moreover, while the financial sector faces strong headwinds, there will be positive countervailing forces. Thus, the industry will benefit from savers’ efforts to rebuild their wealth, while in the emerging markets there is still scope for structural expansion of financial services. Strongly-branded survivors will benefit from higher margins as competitors disappear from the scene, and public sector led investment initiatives, such as on infrastructure and energy, will present attractive long term opportunities. The new financial world, while chastened and more conservative, will eventually shake off the current gloom.