17 February 2009 Features

 

Crawling from the wreckage

David Bannister

The fallout from the financial crisis is going to have long-term ramifications for the structure of the industry

You can take this as good news or bad, depending on your personality: Charlie McCreevy, the European Commissioner for Internal Market and Services, told a conference last month, "we are almost certainly only halfway through the storm and any firm conclusions on long term solutions must be tentative at this time".

McCreevy said that it is still too soon to make predictions as to the shape of future regulation, and the next step is to wait for the high level group headed by former Bank of France Governor, Jacques de Larosiere, to make its recommendations towards the end of this month for EU leaders to discuss in March.

"I suspect we will never get anything near unanimity on what went wrong and how to put it right because people's perceptions and conclusions are invariably coloured by the role they played or didn't play in contributing to the current sorry mess," said McCreevy. "There are some issues on which there has been broad consensus: the scale of irresponsible origination and underwriting, lack of due diligence, toxic securitisation, and wreckless credit ratings was far greater in the United States than anywhere else

"That said, European banks bought into these toxic securities and in Europe there is now a broad consensus that our supervisory systems are not and have not been up to the mark or fit for purpose - not fit for purpose at an EU institutional level, not fit for purpose at a Member State level. With cross-border banking groups now accounting for 80%of Europe's banking assets the absence of formal mechanisms for dealing with a situation where one of those banks gets into serious difficulties, for adequate exchange of information, or for burden sharing was and is an unacceptable gap in our regulatory and supervisory framework."

Not surprisingly, McCreevy says that there will have to be a substantial change to the regulatory structure in Europe. "It must now be clear to everyone that there is a growing gap between the EU supervisory structure, which is primarily organised on a national basis, and market developments, where integration and internationalisation lead to complex interdependencies and growing spill-over effects," he said. "The crisis has brought into sharp relief the weaknesses of the present arrangements, in particular, significant coordination problems and conflicts of interest between Member States."

More surprisingly, McCreevy is sceptical about the likelihood of overcoming this. "Bold steps are needed but there are very different ideas on how to go about it - indeed there is a good deal of hypocrisy and double-speak too: while Member State governments are pretty well unanimous that the issue needs to be addressed, the fact is that any time over the past decade when proposals, however modest, have been put forward to address them the consensus breaks down."

That the crisis underscores the global nature of interrelationships and interdependencies that are truly global in nature is echoed by Michael Bodson, executive managing director, DTCC Business Management & Strategy. "There is certainly a growing realisation that many of the new instruments trade globally, and more and more firms are trading and investing globally. In order to effectively regulate, there has to be more coordination between countries and the regulators in those countries. There will, however, continue to be differences, and it is unlikely that national regulators and governments will want to cede control to an international body at this time. So while we may see more consultation and cooperation among various national regulatory agencies, we don't think it likely that an international regulator will develop any time soon."

While regulators like McCreevy see the opportunity and need to restructure the legal landscape, others had thought that the crisis might push the development of industry-wide changes, such as the emergence of a single industry infrastructure for clearing and settlement.

Bodson is unconvinced. "That certainly seems highly unlikely for Europe in the immediate future. It took more than 20 years for DTCC to become the single clearing and settlement infrastructure for the US, with regional clearing houses and depositories choosing to exit that business, and that was under a single regulatory regime, single currency and single culture," he said. "Europe's nations and therefore their legal systems and regulatory regimes are much more diverse. So while there may be some consolidation this year in the number of clearing and settlement organisations, it will take some time to get down to a more reasonable number. We think it is highly unlikely that there will be a single clearing and settlement organisation for Europe in the near or mid-term future. More likely there will be a small number which dominate the landscape, but even that may not happen for some time."

Bob McDowell, European research director at TowerGroup also points out the clash between globalisation issues and national politics. "The events of the last year will lead to something of a renaissance in 2009 in the way that the finance industry is regulated," he says. "While regulation will be, and must be, guided globally, national regulators are likely to show signs of a more protectionist approach to regulation after the recapitalisation investments of 2008, with governments demonstrating a more vested interest in financial activity."

TowerGroup reckons that the events of the last year will result in a return to a global model of financial services regulation that mirrors the 1944 Bretton Woods agreement. This development is necessary but will uncover tension between national, regional and global approaches to regulation within Europe and around the world.

The 1944 Bretton Woods agreement was the solution the Allied nations adopted to rebuild the international economic system after World War Two. The agreement was abandoned in 1971 after the fixed exchange rate between gold and the US dollar ended. TowerGroup predicts that the recent financial crisis will require national and pan-national governments and financial authorities to work with the International Money Fund and Bank of International Settlements to create a unilateral approach to governance that will echo Bretton Woods.

Aside from the regulatory issues, TowerGroup suggests that a lack of available capital will result in less securities trading and a renewed focus on asset management services as businesses adapt to less risky investment models. Investors will be offered value-added advisory services by their investment managers in an attempt to recoup fee-based revenues, and investment management firms will employ technology at a tactical level to highlight markets of risk and enable enhanced regulatory reporting.

McDowall says: "There will be less capital to play with in 2009 and businesses will be very cautious about high-risk investment strategies. Technology will play a big role in monitoring risk, reducing operations costs and meeting enhanced regulatory reporting demands."

The question of risk is central to how long it will take to get back to whatever turns out to be the new normal, and is one of the key items on the regulators' agenda.

"Let's be clear: the fundamental flaw in the financial theory underlying value at risk models that justified unsustainable levels of leverage needs to be widely exposed," said McCreevy. "It is, of course, the case that diversification among less than perfectly correlated assets should reduce the overall risk of a portfolio below the risk of the sum of its parts. But as is now clear for all to see that theory is only of relevance to individual portfolio positions.

"Extrapolating the benefits of diversification to highly integrated global capital markets and then embedding the supposed benefits in prudential regulation is, it seems to me, a composition based on a fallacy. While an individual might be able to lower the risk of a personal investment portfolio via diversification, it should be obvious that the global financial system as a whole cannot diversify out of itself. Nor can the dozen or so global banks which dominate that system.  While the models they use may be academically and mathematically brilliant the empirical evidence now available demonstrates beyond doubt that in the real world we inhabit they are fundamentally flawed."

This will have substantial knock-on effects. "Previously, financial firms were encouraged to take more risks. They will now take on little if any risk. There was a move to deregulate many areas. Now there will be a move to regulate more areas. Individuals were encouraged to invest in the market for their retirement. Those individuals may now seek safer places to put their money," says Bodson. "For too many, 2008 and 2009 will be remembered as years when they lost their jobs, their investments, their homes. It is and will be a major shock that will take years to recover from, and will likely long influence actions well beyond the time of the actual events. And that will have a significant impact on the growth and development of financial services and many of the complex instruments that were traded in the past.

"There will be continued consolidation in the industry as stronger firms buy out weaker firms, and weaker firms who cannot find a buyer go out of business entirely. The excess capacity within the industry that has existed for quite a few years is finally being dealt with. Even financial firms who are well managed and strong will be more conservative and risk-adverse in making loans, even to reasonably good prospects, so credit will likely remain tight."

George Ravich, vice president of marketing at transaction systems specialist Fundtech, says there are some signs of activity in the market as small- to-medium banks are mow less worried about being swallowed up by the industry giants. "Those banks are doing well. They are getting new relationships and they are looking at how they service those clients," he says. "The smart ones are seeing it as an opportunity - they are no longer the victims of a scale business - and they are getting on with old-fashioned banking."

Old-fashioned banking - it's the future.