Traders in the financial markets are feeling overwhelmed by the sheer velocity of important news headlines. The intense atmosphere of the financial crisis means that day-to-day management of capital is now absorbing all of our attention. But the future of finance is going to be very different from what we have known in recent years. The regulatory landscape is going to change dramatically and investor interests are going to be different, transforming the economic landscape as a whole.
First, traditional financial regulation in the past has focused on the type of institution in question. Commercial banks with depositors have been overseen by bank regulators. Brokerages have been subject to SEC rules. Hedge funds have been, to a large extent, exempt. Going forward, it seems that US regulators are determined to deal with institutions on the basis of systemic risk calculation. In other words, all institutions that pose a potentially systemic risk will have capital adequacy rules, risk management rules and legal foundations for a managed takeover if they fail. That means hedge funds and brokerages will fall under the oversight of the Fed or some new super “systemic risk” regulator. This helps explain why the Fed has been inviting some of the big hedge funds into meetings with market participants recently. In the past, only the regulated firms were invited. These changes will apply to Fannie and Freddie as well. Will they apply to, say, General Motors or United Airlines? Perhaps and perhaps not. It is too soon to tell, but one suspects that bond insurers like MBIA or AMBAC would fall under the new “systemic risk” approach.
The legal foundations for this will take time. But we can already see that regulators from the US to Switzerland to Singapore will be seeking to make the following changes to the rules of the game:
1. Stricter controls over off-balance sheet leveraged risk. No longer will these activities be deemed “not material” from an accounting, legal or regulatory point of view.
2. Gramm-Leach-Bliley, the legislation that allowed Citibank to become Citigroup, will gradually be reversed. We will find ourselves more in a Glass-Steagall Act world, where commercial banks will not be permitted to engage in investment banking activities. Citigroup will shrink back into Citibank. Vikram Pandit has started this process by selling any and all assets that are saleable.
3. Firms that sell risk (say, through securitisation) must continue to own some of it. People who buy securitised products will be vetted by the government first. Only sophisticated investors like pension funds will be allowed to buy – but they probably won’t want to.
4. Securitisation will be done with barcodes. In other words, every securitised transaction will come with an ID number that allows an investor to “see” what is in the asset they are buying, or how the composition of assets within a security is changing over time.
5. Value at Risk will no longer be relied upon as the main measure of risk. Other risk-management techniques will be required and they will probably be increasingly left to independent third-party entities. Basel III, the next round of international banking reforms, will not assume financial firms can be trusted to come up with or stick to their own risk models the way Basel II did.
6. All new risk-control mechanisms will have longer time frames. In the past, the VAR models assumed that yesterday’s price information was less relevant than today’s price information. Five years of data will no longer be acceptable to regulators. Now they will want ten to 20 years’ worth.
7. The capital charge associated with almost any financial activity will be higher.
8. Investment banking and brokerage activities that give rise to conflicts of interest will be hived off into third-party hands: prime brokerage will probably be the prime target. The use of a private banking arm to distribute in-house products will probably come under pressure as well.
9. Commercial banks will be required to pay more insurance. The cost of the FDIC (Federal Deposit Insurance Corporation) in the US is bound to go up and, internationally, countries will now want to introduce something like an FDIC.
10. Securities lending will move onto electronic platforms. Prime brokers within investment banks will no longer be able to take 66 cents on each dollar of SEC lending when pension funds and hedge funds can deal directly over electronic exchanges.
11. Bonuses will be paid on the basis of several years of performance rather than a single year. More will be paid in stock and less in cash. Bonuses will increasingly be tied to the life of a deal rather than to a calendar date.
This is not an exhaustive list, but it begins to demonstrate how very different the risk landscape will look in the near future. All of these changes involve the following basic elements: the cost of operating a financial business will be higher and the profit margins will be lower. Financial markets will have to figure out a new system for creating leverage, because the old system will not be allowed to generate the kind of leverage we are all used to. That means investments have to actually perform. We cannot depend on leverage to make the returns look good. This means there is now a premium on skill rather than size. The mega mergers and acquisitions of the last few years will now be reversed as big firms sell off non-core business and break up their franchises.
The Consequences
It is not only the changed regulatory landscape that will affect the financial markets. The economic landscape of the last 20 years may well turn out to be an aberration. Certainly the lack of inflation and the dependably low interest-rate environment will probably come to be seen as a privileged and exceptional situation rather than being taken for granted.
In the new world economy, inflation will not be as well contained, interest rates will not be so low and real returns will be harder to achieve. This implies a somewhat slower-growth world economy. Then again, that may not be such a bad thing after recent experience.
A higher-inflation environment will compel fund managers and investors to focus less on reaching for performance and more on preserving the value of their capital. People will begin to distinguish again between nominal and real rates of return.
The cost of capital is also going to be higher than in the past. The credit crunch is making it very difficult to access capital at a reasonable price, but one suspects it will not be as cheap as it was for many years to come.
Taken together, these new economic circumstances combined with the new regulatory landscape will compel the following changes on the financial services industry.
1. The most important consequence of these changes is simply that more capital will flow into the hands of owner/operators of businesses who have the opportunity to grow or preserve margins, and less capital will flow into the hands of financial engineers who know how to leverage up and generate returns.
2. Cash flow now is more important than expected future valuation.
3. Margin management will take priority over traditional measures. For example, equity analysts will be less focused on PE ratios and more focused on cash flow, cost management and pricing power arising from brand positioning.
4. The quantity of deals used to be the key to valuation. Now the market will reward the quality of deals.
5. Size will matter less than skill. Boutiques will have an advantage over banks and large fund managers.
6. Real returns will matter more than nominal returns.
7. Investors will care less about risk buckets (which did not protect them from losses) and allocate more according to investment themes.
8. Institutional investors will be more focused on liability management than performance management.
9. All the trauma and knock-on effects from the lists above will make consumers care more about quality and endurance than cheapness and fashionability.
My view is that the next wave of IPOs and billionaires arising from these changes will become apparent in about five years’ time. By then, the people who founded the new companies that will capture these changes will have moved out of the rental office space they are picking up for a song at the moment. These are the people who have just been, or are about to be, fired from investment banks. Looking back they will say it was the best thing that ever happened to them. For those who “get it” the future will be very, very bright.