Oliver Wyman - Evolution of Financial Services - Dec 07

Just as some species become extinct in

nature, some new financing techniques

may prove to be less successful than others. “

”

Assistant Secretary of the Treasury for Financial Markets

Anthony W. Ryan before Congress in September 2007

Evolutionof

THE

Financial Services

by Niall Ferguson and Oliver Wyman

Making Sense of the Past, Preparing for the Future

Oliver Wyman is a leading global management consultancy www.oliverwyman.com

COntentS

executive Summary 9

Introduction 12

1 the consensus view of the industry 16

2 A century of change in global financial services 28

3 Of cycles, surges and spasms 46

4 the role of regulation: Intelligent design? 66

5 evolutionary lessons in financial services 75

6 Concluding remarks 99

Bibliography 100

Acknowledgments 105

�THE EvoluTion of financial sErvicEs

exeCutIve SuMMAryThe objectives of this report are to test the consensus view of the financial services industry against long-run historical data and to form insights that are based on more than just the last few years.

We find that many widely-held views are not safe when considered in the light of several economic cycles. exogenous factors often identified as core engines of finance growth in the early twenty-first century (stable macroeconomic growth, high liquidity and global integration) have been subject to sudden reversal in the past, and cannot be relied upon to continue in the future. At the same time, factors commonly cited as posing near-term threats to the financial services sector (changing demographics and global imbalances) may have acted as growth drivers for the industry.

The consensus view also takes for granted continued improvements in technology, risk management and good governance. The historical record, however, suggests that such endogenous sources of growth have not advanced in a linear fashion. Similarly, we question the assumption that there will be inexorable institutional convergence (as best practice spreads) and concentration (because of economies of scale). In contrast, we find a proliferation of forms in the industry and a tendency for institutional diversity to persist.

tracing the evolution of financial services over more than a hundred years allows us to set our own times in an unusually broad perspective. A crucial point is that the financial world today is much more like that of the beginning of this period than that of any intervening period. From 1914 to 1980 there were two world wars, multiple revolutions, a Great Depression and a Great Inflation – to say nothing of the exclusion of more than half of humanity from the global economic order, thanks to the spread of Communism. During this time liquidity waxed and waned, sometimes with astonishing speed. Demand for financial products grew in aggregate but was highly volatile in individual segments. Financial services were provided by a whole host of different supplier forms that came and went at a remarkably rapid pace. regulatory structures went through major dislocations, frequently in response to unforeseen crises. In this light, it would be highly optimistic to project forward the relative calm of the last decade. The future will not be simply a continuation of the recent past. Indeed, as we have been writing this study, volatility has already returned to financial markets.

The long-run view has led us to the intriguing notion that financial services is neither a deterministic nor a wholly stochastic system, but an evolutionary one. When making pragmatic decisions, we do not discern perennial “golden rules”. nor can we afford to wait for the infrequent appearance of “black swans”. We do, however, see many similarities to the process of biological evolution, which we believe can explain observed phenomena and – by extension – provide future guidance.

1010

At any given time, the financial services sector is populated by many different institutional forms competing for resources. As in the natural world, there is persistent (though not random) mutation. As in the natural world, the environment is characterised by punctuated equilibrium: the macroeconomic environment can change spontaneously or the rules can be changed by regulatory intervention. Importantly, extinction is an integral part of the system – those kinds of firms that under-perform and fail to adapt ultimately disappear. We do not posit evolution as simply an interesting analogy but as a better framework for understanding industry trends, cycles and events. While there are important differences between biological and financial evolution, three fundamental similarities stand out. First, neither system has a single end-goal – looking for this or planning around its assumed shape are futile. Second, no formula works forever – today’s successes will be tomorrow’s failures unless they adapt and innovate. Third, mutation is part of the system – spontaneous innovation is to be expected and should be encouraged.

A new framework also gives us new pointers for the future and offers valuable lessons for those running the industry today. The boards and executive officers of financial services firms would do well to

Keep it natural: growth works best when it is based on real advantage and organic innovation

Discard industrial plans: because evolution does not work in neat five-year planning cycles, continuous out-execution (with bold moves where necessary) beats grand strategic designs

Make yourself more attractive: winning the competition for talent, capital, customers and other resources is paramount to longevity

Worry more about habitats and less about competitors: obsessions with competitors can stunt innovation and miss big waves that lead to habitat loss for all

Buy insurance: extreme shocks will almost certainly happen in the future – effective risk assessment should lead beyond conventional insurance to the development of “re-birth” plans

These lessons, emanating from the evolutionary perspective of finance, are quite different from the consensus imperatives of “get bigger”, “diversify”, or “stick to your knitting”. This contrast is even greater when the implications for regulators, supervisors and policy-makers are considered. “Intelligent design” of the underlying rules of the game seems like the logical role for this privileged group of industry leaders. On closer inspection, however, regulators stand little chance of designing timeless rules for a constantly evolving system.

11THE EvoluTion of financial sErvicEs

We regard this report as the first, rather than the last, word in forming a clearer view of the financial services industry – soon to account for 10% of global production. Without such a long-term perspective, current and future industry leaders will struggle to run a critical sector of the economy that in some way underpins most other sectors.

12

IntrODuCtIOnFew would dispute that the past ten years have witnessed dramatic changes in the financial services sector around the world: deregulation, globalisation, privatisation and securitisation, to name but a few. yet the full magnitude of these changes and their implications for the future can be appreciated only if they are put in a longer-term perspective. In this report, we attempt to take the long view, tracing the major developments in world finance over roughly a century, and casting doubt on what we identify as the consensus view on the future of financial services. Our analysis shows that financial development follows an evolutionary pattern, similar in character to that witnessed in the natural world, though within a much more compressed time frame.1 We believe this has important implications for both financial firms and regulators, at a time when the global macroeconomic environment may be in the early stages of a profound change.

It may strike some readers as commonplace that the financial services sector resembles an evolutionary eco-system. Quasi-Darwinian language (“only the strong survive”) is frequently heard on both Wall Street and Lombard Street. However, previous discussions of financial evolution have tended to be content with superficial analogies based on rather limited understanding of neo-Darwinian thought.2 In fact, the financial services industry has many of the defining characteristics of a true evolutionary system

“Genes”, in the sense that certain business practices perform the same role as genes in biology, allowing information to be stored in the “organisational memory” and passed on from individual to individual or from firm to firm when a new firm is created

The potential for spontaneous “mutation”, usually referred to in the economic world as innovation and primarily, though by no means always, technological

Competition between individuals within a species for resources, with the outcomes in terms of longevity and proliferation determining which business practices persist

A mechanism for natural selection through the market allocation of capital and human resources and the possibility of death in cases of under-performance, i.e. “differential survival”

1 ThenotionthatDarwinianprocessesmaybeatworkintheeconomyisnotnew.ThorsteinVeblen(18�8)raisedthequestionandJosephSchumpeter(1�43)wasscepticalabouttheapplicabilityofDarwin’sideastotheprocessofeconomicexchange.Thepath-breakingcontributionswerebyAlchian(1�50)andNelsonandWinter(1�82).Since1��1therehasbeenanentirejournaldevotedtothesubject,The Journal of Evolutionary Economics.Theevolutionarymodelneverthelessremainsoutsidethemainstreamofeconomics,wheretheneoclassicalgeneralequilibriumapproachremainsdominant

2 Seee.g.Kindelberger(1�84),pp.85


Scope for speciation, sustaining bio-diversity through the creation of wholly new “species” of financial institutions, thereby avoiding the danger that natural selection ultimately produces a world with only one version of “the fittest”

Scope for extinction, with species dying out altogether

Financial history is, in sum, the result of institutional mutation and natural selection. random “drift” (innovations/mutations that are not promoted by natural selection, but just happen) and “flow” (innovations/mutations that are caused when, say, American practices are adopted by Chinese banks) play a part. There can also be “co-evolution”, when different financial species work and adapt together. But market selection is the main driver. Financial organisms are in competition with one another for finite resources (customers, clients, market share). At certain times and in certain places, certain financial species may become dominant. But innovations by competitor species, or the emergence of altogether new species, prevent any permanent hierarchy or monoculture from emerging. Broadly speaking, the law of the “survival of the fittest” applies. Institutions with a “selfish gene” that is good at self-replication (and self-perpetuation) will tend to endure and proliferate.3 note that this may not result in the evolution of the perfect organism. A “good enough” mutation will achieve dominance if it happens in the right place at the right time, because of the sensitivity of the evolutionary process to initial conditions; that is, an initial slim advantage may translate into a prolonged period of dominance, without necessarily being optimal.

nevertheless, this process is not wholly endogenous. Periodic exogenous shocks can radically alter the evolutionary environment, rendering certain evolved traits disadvantageous that previously had been advantageous, and vice versa. Financial disruptions (like the Great Depression of the 1930s or the Great Inflation of the 1970s) are like the asteroid strikes and ice ages that periodically intervened in the evolutionary story of life on earth.4 In extreme cases, they can cause mass extinctions of financial species; in milder cases, when environmental change is more gradual or less profound, they eliminate the less fit members.

Finally, it is worth bearing in mind that in the natural world, evolution is not progressive, as used to be thought (notably by the followers of Herbert Spencer). Primitive financial life-forms are not condemned to oblivion, any more than the microscopic prokaryotes that still account for the majority of earth’s species. evolved complexity protects neither an organism nor a firm against extinction – the fate of most animal and plant species.

3 Dawkins(1�8�)

4 Gould(1�8�)

14

The analogy is, admittedly, not perfect. Firms are not quite the same as biological organisms. When one organism ingests another in the natural world, it is just eating, whereas in the world of financial services, mergers and acquisitions can lead directly to mutation. In financial organisms, there is no counterpart to the role of sexual reproduction in the animal world (though demotic sexual language is often used to describe certain kinds of financial transaction). In financial organisms, most mutation is deliberate, conscious innovation, rather than random change. Indeed, because a firm can adapt within its own lifetime to change going on around it, financial evolution (like cultural evolution) may be more Lamarckian than Darwinian in character. And in the natural world there are no regulators or governments. Still, the following summary of evolutionary theory by an eminent biologist is at least suggestive that the resemblances outnumber the differences.

The ultimate purpose in life [is] to be better than your neighbour at getting genes into future generations, in which those successful genes provide the message that instructs the development of the next generation, in which that message is always “exploit your environment, including your friends and relatives, so as to maximise our genes’ success”, in which the closest thing to a golden rule is “don’t cheat, unless it is likely to provide a net benefit”.�

taking the long view, we can discern some of the most important trends in the evolution of financial services, and identify possible future developments as both natural selection and intermittent shocks exert their influence on the population and forms of financial institutions.

The conventional view of financial development tends to see the process from the vantage point of the successful survivor firm. In the firm’s official “family tree”, numerous small firms are seen to converge over time on a common “trunk”, the present-day conglomerate. However, this is precisely the wrong way to think about financial evolution. Over the long run, financial innovation begins at a common trunk. Over time, the trunk branches outwards as new kinds of banks and other financial institutions evolve. The fact that a particular firm successfully devours smaller firms along the way is more or less irrelevant. In the evolutionary process, animals eat one another, but that is not the driving force behind evolutionary mutation and the emergence of new species and sub-species.

5 GeorgeC.Williams,quotedinDawkins(2003),p.8.


The implication is that economies of scale and scope are not always the driving force in financial history. More often, the real drivers are the process of “speciation” – whereby entirely new types of firms are created – and the equally recurrent process of “creative destruction” – whereby weaker firms die out or, more commonly, get “eaten”. These processes are often accelerated in times of economic disruption. regulators must be careful not to impede them out of a misguided sense that established firms are all “too big to fail”.

16

1 tHe COnSenSuS vIeW OF tHe InDuStry

We begin by summarising what we see as the prevailing consensus on the state of the financial services industry – the view held by most investors, analysts, regulators, managers and media observers based on trends of the past decade.

For the most part, the sector is thriving in a benign global economic environment. For the past 10 years, the world economy has been growing at an average annual rate of ~4% p.a. and keeping unemployment levels below 10% in most developed countries. Wealth creation and economic liberalisation – the two fundamental drivers of financial services growth– have been sustained and are spreading among international economies.

There are, admittedly, several potential threats to this benign environment, such as the ageing of the population, global imbalances (notably the uS current account deficit), bubbles in emerging economies, continuing volatility in credit markets, climate change, and the threat of terrorism. But these seem too remote, too uncertain, or too limited in scale to have a profound impact on the provision and consumption of financial services in the decade ahead.

At the same time, regulators, policy makers, and competition authorities are, by historical standards, doing a good job of protecting consumers and maintaining financial stability. While the cost of regulation relative to the size of the industry is increasing, the benefits of supervision (such as fewer bank failures) are becoming more tangible; the fiscal and monetary policy mix has also contributed to a marked reduction in macroeconomic volatility. The principal threat to the sector may come not from excessive regulation but from innovations (for example in the derivatives market) beyond the control of established monetary and regulatory authorities.

under these conditions, according to the conventional view, it is no surprise that the financial services sector has attained new peaks

total industry value is ~$6 tn, up 60% over the last ten years

total revenues are ~$2.7 tn, accounting for 7% of global GDP and rising

return on capital is the highest ever: 20% at year end 20066

employment in the sector is at its highest level ever

Loss rates are still below cyclical averages, despite recent write-downs arising from the sub-prime mortgage defaults and the credit crunch in the market for collateralised debt obligations and other asset-backed securities

6 “UnityinAdversity”,The Economist,September6,2007


Banks, insurers, asset managers, and other providers of financial services have become better at innovation, marketing, production, risk management, and governance. Customers (be they individuals, corporations, or public enterprises) have an unprecedented choice of financial products and providers. More important, they have better ways of determining which products and services are best for them, not least because of the spread of transparency through the Internet.

The consensus view is that the financial services sector is about to progress from one golden decade to another, despite occasional and inevitable business cycle setbacks. In figure 1, we have integrated multiple quantitative and qualitative views to create a picture of financial services growth over the past decade, which projects revenue growth of 77% in combined global financial services revenues between now and 2017.

1.GlobAlfiNANCiAlSerViCeSreVeNUeSforThelASTANDNexTDeCADe

5000

1,000

2,000

1,500

2,500

3,500

3,000

4,0004,500

North America Europe Asia Pacific

1997

1998

2006

2004

2003

2002

2001

2000

1999

2007

2005

2008

2009

2017

2015

2014

2013

2012

2011

2010

2016

Latin America Rest of World

Source: oliverWyman,ThefutureoffinancialServices(2005)

Such an optimistic consensus view seems to be predicated on the continuation of several key trends. Some are positive, others are negative, but overall the outlook is highly optimistic.

18

ASUpporTiVemACroeCoNomiCpoliCyCoNTexT

An important factor in the recent period of sustained growth and low inflation (see figure 2) is that the world is currently enjoying (in the words of The Economist) an “unusually benign economic climate”7 and relative political stability. Political unrest and conflict have been minimal in europe, the Americas, and large parts of Asia. Only Sub-Saharan Africa, parts of the Middle east, and a handful of other failed states (e.g. Haiti) are still crippled by internal instability.

Although progress has slowed in the World trade Organization’s Doha round, there has been no significant upturn in protectionism. trade in goods and services has continued to grow, with exports still the key driver of growth in Asia. Capital controls have become the exception rather than the rule. restrictions on immigration have not prevented unprecedented integration of the global labour market, with measurable impacts on service sector labour costs and on manufacturing.

At the same time, there have been significant improvements at the national level in both fiscal and monetary policy. Fiscal deficits have not been eliminated, but they have generally been kept below the 5% of GDP threshold, and financed in a non-inflationary way (through bond sales). Monetary authorities, having largely won the battle against high inflation in the 1980s, have adopted a variety of different approaches with the common objectives of price stability (a consumer price inflation rate of below 3%) and sustainable growth (a growth rate that does not exceed or undershoot productive capacity).

to prevent a repeat of the Asian crisis of 1997-8, Asian central banks have adopted more or less pegged exchange rates and accumulated very large foreign exchange reserves. Their huge accumulations of dollars and dollar-denominated bonds have tended to depress long-term interest rates in the united States, which might otherwise have risen further as a result of the deficits due to the 2001-2 recession, the Bush administration’s tax cuts and its lavish expenditure at home and abroad. Here, too, the consensus view is of a benign global environment for financial services.

Perhaps the most heartening news of all, in this mainstream view, is the recent and projected growth of the biggest emerging economies – Brazil, russia, India, and China – as well as the many smaller countries benefiting from economic openness. In China, a fifth of humanity is on the march. With an average rate of real per capita GDP growth of 8.4% since 1978, the Chinese economy has increased in size by a factor of ten. According to calculations by Goldman Sachs, the ratio of uS per capita income to China’s per capita income is now approximately 23 to 1. By 2050, however, the ratio could be less than 3 to 1. This implies an extraordinarily rapid convergence.

7 “TheAlchemistsoffinance”,The Economist,may17,2007

1�THE EvoluTion of financial sErvicEs

2.GlobAlGDpGroWTh,iNflATioNrATeSANDiNTereSTrATeS

%19

70

1972

1989

1985

1983

1981

1978

1976

1974

1991

1987

1995

1997

1993

2001

2003

1999

2005

-10

10

15

25

20

30

-5

0

5

GDP growth Inflation rate Interest rate

Source: mitchell(2003),oeCD,oliverWymananalysis

hiGhliqUiDiTy,effiCieNCyANDGlobAliNTeGrATioN

Though the recent crunch has reduced the availability of credit in many markets, liquidity is still high. The availability of capital has allowed – even forced – investors to diversify their holdings into increasingly exotic asset classes (such as special situations, distressed debt, art, and wine) which, along with traditional assets, enjoyed a long and largely uninterrupted bull run from 2003 until the summer of 2007. The recent efforts of some central banks to try to avert a credit crunch have only increased liquidity. Some worry that excessive liquidity could fuel either consumer price inflation or bubbles in one or more asset classes. But most market participants plainly prefer excessive liquidity to a credit crunch.

In addition to being more liquid than ever, capital markets are also widely believed to be more efficient now than at any point in history, and globally integrated as never before. Frictional costs involved with transferring capital from one financial instrument to another are at an all-time low. Increased efficiency in the capital markets, aided by improvements in technology and greater competition between exchanges, has lowered transaction costs and made the movement of capital freer than at any point in history. Capital flows freely across borders and limits to foreign ownership are being relaxed throughout the developed (if not the developing) world. regulatory barriers to capital movement and ownership have been removed to the extent that, within the developed world, cross-border ownership of assets of most traditional kinds has become very common. For precisely this reason, some countries (mainly in the english-speaking and Mediterranean worlds) have been able to maintain large current account deficits, supported by foreign governments and investors. Financial institutions from developed economies are reinforcing this trend by seeking new revenue opportunities in

20

developing countries (setting up subsidiaries or engaging in joint ventures outside their own mature, low-growth markets) while developing economies invest in highly rated securities originating in more mature financial markets.

TheDemoGrAphiCCoNTexT

Although the global macroeconomic environment seems generally favourable, conventional wisdom holds that demographic changes are likely to create financial problems, particularly in developed nations. As the post-war “baby boom” generation of the developed world begins to retire, dependency rates are set to rise. The proportion of the uS, european, and Japanese population aged 65 and over is expected to increase from 20% today to more than 36% by 2050 (see figure 3).

Most analysts expect this trend to have major financial consequences. retirement-related assets are expected to reach $25 tn by 2010.8 Investment demand will shift from stocks to bonds, the popularity of annuities will rise, and the deficits of the world’s defined-benefit pension funds will be exposed. Governments will likely have to bail out under-funded pension systems, while the working-age population will see their tax burdens rise to pay for the growing number of dependents.

All this may create opportunities for those financial institutions that are able to adapt quickly to the new social order. Wealthy retirees are likely to require new products and services, and are likely to be more financially sophisticated than in the past. nevertheless, most commentators expect these demographic changes to have a negative impact on financial services as a whole.

8 Deloitte(2007)


3.eSTimATeDAGeDiSTribUTioNofUS,eUropeAN,ANDJApANeSepopUlATioN2000-2050

2000

2005

2045

2035

2030

2025

2020

2015

2010

2050

2040

10%0%

20%

40%30%

50%

70%60%

80%90%

100%

<14 15-64 >65

Source: UnitedNations

GlobAlimbAlANCeS

The conventional wisdom also has it that the biggest short-run threat to financial stability arises from global imbalances: the current account deficits of the uS, other “Anglosphere” and Mediterranean countries, and their mirror image, the surpluses of Asian emerging markets and energy-exporting countries. The current account surplus of China is now around $200 Bn, while the country’s foreign exchange reserves stand at well over $1 tn – larger than estimations of even the biggest sovereign wealth funds (see figure 4). Although this state of affairs is sometimes referred to as a “stable disequilibrium,” it is not hard to see how it could become unstable. A major re-alignment of the Chinese currency (estimated to be undervalued by as much as 50%)9 would sharply increase the cost of imported manufactures to the developed world. Similarly, any downturn in the uS economy would have repercussions around the world. It is important to recall that about 20-25% of China’s GDP depends directly on trade with the uS, which accounts for a fifth of Chinese exports.

� Dunaway,andli,(2005)

22

4.ChiNeSebAlANCeofpAymeNTSANDforeiGNexChANGereSerVeS

0.5

0.0

1.0

$TN

1990

1991

2001

1999

1997

1996

1995

1994

1993

1992

2000

1998

2006

2004

2002

2005

2003

-50

150

100

50

-0

200

$BN

Foreign exchange reserves Current accound balance

Source: SAfeChina

Summing up the conventional wisdom, then, the global macroeconomic environment is exceptionally benign from the point of view of financial services. Liquidity remains abundant, despite the credit crunch of August-September 2007. true, demographic trends and global imbalances are worrisome. But the overall outlook is rosy.

How are financial institutions likely to evolve under these circumstances? The consensus view foresees a continuation of the following trends.

CoNTiNUeDrApiDiNNoVATioNANDiNVeSTmeNTiNTeChNoloGy

In recent years, hedge funds and investment banks have found ever more inventive ways to generate returns and structure financial instruments, generating enormous income and wealth in the process. At the same time, simple products have become increasingly commoditised, with firms ever more focused on selling high volumes at low margin.

Financial institutions’ spending on and use of information technology is likely to continue to increase as companies seek to achieve greater productivity. Improving the volume and speed of communication drives competitive advantage in an industry in which information transfer is crucial.

Partly because of technological innovation, the financial services sector is tending to overlap more and more with other industries such as energy, real estate, and healthcare. retailers are venturing into consumer finance and retail banking, while some utilities are starting to trade financial instruments. Industrial companies are holding increasing volumes of interest rate and foreign exchange derivatives, mostly to mitigate the various risks of doing business. non-financial institutions are also increasingly offering


financial services. volkswagen has become one of Germany’s fastest growing financial institutions by financing private used car sales. uK retailer tesco is now in insurance, and WalMart has entered retail banking in Mexico.

At the same time, there is some evidence of speciation within the financial services sector, as new niche markets emerge. Islamic banking, takaful insurance, socially responsible investing, and community banking are all notable areas of growth. As these niches grow, some are likely to cluster around their natural geographical hubs – the Middle east or South-east Asia for Islamic banking and insurance, for example.

improVemeNTSiNriSKmANAGemeNT

The consensus view is that aided by regulation and innovative financial products, financial institutions have raised their risk management techniques to a level of sophistication and effectiveness never seen before. For example, firms are now using derivatives and other tools to diversify balance sheet risk through the purchase of credit default swaps (CDS).

As figure 5 shows, outstanding CDSs have grown from next to nothing 10 years ago to more than $20 tn today. Firms are seeking to remove risk from the balance sheet altogether through the sale of repackaged assets such as mortgage-backed securities (MBS) and asset-backed securities (ABS). new entities like conduits and Structured Investment vehicles (SIvs) have emerged, whose primary purpose is to trade these instruments. While regulatory demands are a burden to financial institutions, new techniques and instruments have allowed banks to lower their risk profiles significantly. recent turbulence in the credit markets and attendant doubts regarding the accuracy of credit ratings are likely to slow progress in this direction, but not to reverse it.

5.GroWThofGlobAlCDSmArKeT

1995

1996

2006

2004

2002

2001

2000

1999

1998

1997

2005

2003

20

15

10

25

$TN

0

5

Source: bbA

24

Financial innovation is happening at a remarkable pace, as traditional balance sheet banking declines in significance. The booming markets for secondary securities such as corporate mortgage backed securities (CMBS) and retail mortgage backed securities (rMBS – see figure 6) are testament to this decline. Combined issuance of ABS and MBS has grown from nothing in the mid 1980s to over $3 tn annually. Indeed, packaging and removing risk from the balance sheet is increasingly being seen as the most important skill in banking. While gathering assets in the form of deposits is still important, originating loans and holding them on the balance sheet is no longer considered the way to run a successful bank.

6.GroWThofGlobAlAbSANDmbSiSSUANCe

ABSMBS

0

500

1,000

1,500

2,000

2,500

3,000

1980

1982

2006

2002

1998

1994

1992

1990

1988

1986

1984

2004

2000

1996

$BN

Source: Thomsonfinancial,federalreservebankofNewyork

traditional securities exchanges are declining in significance and are expected to decline in number. electronic exchanges are taking their place, and over-the-counter (OtC) sales of complex financial instruments are increasingly common. In response to these pressures, exchanges are consolidating, seeking strength through greater volumes of business and by forging complementary partnerships both regionally and globally. The exchange of tomorrow is likely to be an entirely virtual entity, replacing the bricks and mortar exchanges of the past.

25THE EvoluTion of financial sErvicEs 25THE EvoluTion of financial sErvicEs

GoVerNANCeANDiNSTiTUTioNAlformS

until recently, it was widely believed that the long-term trend in financial services was for consolidation and the emergence of an ever-smaller number of ever-larger firms – a tendency symbolised by the creation of Citigroup, HSBC, and other large multi-business, multi-geography providers. This long-term trend towards concentration seemed to follow the logic of economies of scale and scope, as experienced by other mature industrial sectors of the economy in the twentieth century.

A recent change in sentiment seems to be driven by scepticism about cross-border ownership structures and the risks hidden in highly complex, diverse organisations. This new, more nuanced view sees further industry-wide consolidation (especially in countries where finance is fragmented, such as the uS, Germany, and Italy) but emphasises industrial logic as well as sheer size.

Another recent development is the increased degree of activism within the financial services shareholder base. The rise of private equity partnerships, hedge funds, and other “professional” investors (e.g., insurance companies, pension and mutual fund managers) has created a much more knowledgeable and active shareholder base. The consensus view is that publicly quoted financial corporations will increasingly be influenced, both directly and indirectly, by activist investors. The recent experiences of Deutsche Börse, the London Stock exchange, and other entities identified as targets by private equity acquirers are testament to the rising activism of the sophisticated shareholder.

SUperViSioNANDreGUlATioN

Another threat identified by most commentators is cumbersome regulation. Sarbanes-Oxley, Basel II, Solvency II, MiFID, and IFrS are likely to increase costs for financial services companies by forcing them to enlarge their legal, accounting, and compliance divisions. regulations are likely to become even more burdensome in the areas of privacy, security, partnership, and operational risk, since nearly all the new regimes push for higher standards of transparency, accountability, and corporate governance. Compliance failure brings its own new risks, so additional regulations paradoxically can make the world a more risky place for financial services companies, even if their net effect is to increase systemic stability.

26

oVerVieW

In this chapter, we have identified a number of themes which define the conventional wisdom on the financial services sector, based on experiences of the past decade

At the international and national level, trade, fiscal and monetary policy offer a benign combination of liberalisation, counter-cyclical stabilisation, and low inflation that is not about to disappear

very high levels of liquidity will continue, as will high levels of global integration and capital market efficiency

Demographic trends will move a large proportion of the population into retirement, which may create shifting and unpredictable demands for financial products

Global imbalances will persist, which could lead to potential instability if, for example, China’s currency were to appreciate sharply

The outlook for the sector is also somewhat ambivalent, though again on balance positive

High rates of innovation and improvements in technology will continue

Sophisticated risk management and transfer techniques will continue to marginalise traditional banks and exchanges

Shareholder activism will also increase, imposing changes in the governance and ownership structures of financial services organisations

Supervision and regulation will continue to impose costs as well as systemic benefits


From the perspective of different industry stakeholders, this is how the conventional wisdom looks:

Consumer

increasedcomplexityofoffering

proliferatingproductranges

increasingtechnologicalsophistication

Employee

Sizeofemployerasacompanygrowing

increasingspecialisationandcomplexityofroleswithinorganisations

increasingoutsourcingabroad

Investor

highdegreeofcyclicalityinfSstocksasinvestments

increasingm&Aactivity

increasingprivateequityactivityandactivism

Manager

paymorefrequentlyperformance-linked

Competitionasfiercenowasever

regulationsincreasinglyburdensome

Regulator

industrymovingmoreandmoretowardsrisk-basedframeworks

Stabilityanddiversificationarethemostimportanttrends,thoughcapitalmarketsaremovingthesectorintotheunknown

Service provider

increasingcomplexityofoperationsandsystems

oneofthelargestcustomersegments(especiallyfortechnology)

It seems to us that the answers to most of the challenges now facing financial services are broadly couched in terms of product design and distribution, regulation, management and incentive structures. It is widely assumed that “best practice” is being rolled out globally in all areas of the industry.

28

2 A Century OF CHAnGe In GLOBAL FInAnCIAL ServICeS

The consensus view is largely based on extrapolation of trends from the past decade. Thinking in terms of evolutionary patterns, however, forces us to take a longer view. If we expand our horizons to consider the past century, we see that

economic stability and global integration have varied enormously

Liquidity has fluctuated widely

Global integration has been reversed more than once

Financial systems have been faced with high dependency ratios before now

Global imbalances are less of a novelty – and perhaps less of a hazard – than a short-term perspective might lead us to assume

eCoNomiCGroWThANDiNflATioN

Though the past decade has seen economic stability, the norm in recent history has been instability. The twentieth century has seen extreme economic instability, with significant variations in the growth rate, inflation, and unemployment. The average rate of inflation was 0.6% from 1870 to 1914, 8.5% from 1914 to 1945, and 6.6% from 1945 to 1989. Only since 1990 has inflation settled to an average rate of 1.1%. nominal GDP growth from 1870 to 1914 averaged 2.5%, 5.3% from 1914 to 1945, and 8.6% from 1945 to 1989. Since 1990, GDP growth has averaged 4.9% (see figure 7).

2�THE EvoluTion of financial sErvicEs 2�THE EvoluTion of financial sErvicEs

7.mACroeCoNomiCiNSTAbiliTyiNTheTWeNTieThCeNTUry

70%

60%

50%

40%

30%

20%

10%

-10%

-20%

-30%1870 1878 1886 1894 1902 1910 1918 1926 1934 1942 1950 1958 1966 19741982 1990 1998 2006

0

Nominal GDP Growth Inflation rate

Source: mitchell(2003),liesner(1�8�),USCensusbureau,UKNationalStatistics,UnitedNations.CountriesincludedareUS,Japan,UK,Spain,italy,Germany,franceandSwitzerland

From 1880 to 1914, the standard deviations of GDP growth and the inflation rate were 3.7 and 3.4 respectively. From 1914 to 1945, volatility was very high at 6.8 and 7.7, and neither measure passed below 1880-1914 levels until 1956. Since 1994, volatility has been much lower than historic rates, at 2.0 and 1.2 on average (see figures 8 and 9).

30

8.GDpVolATiliTyiNTheTWeNTieThCeNTUry

1880

1887

1894

1901

1908

1915

1922

1929

1936

1943

1950

1957

1964

1971

1978

1985

1992

1999

2006

40%

35%

30%

25%

20%

15%

10%

5%

0%

France UK Germany Japan Italy Spain

US Switzerland Austria Belgium Denmark

Finland Netherlands Norway Sweden

Source: mitchell(2003),oeCD,USbureauofeconomicAnalysis,Carter,Gartner,haines,olmstead,SutchandWright(2006),oliverWymananalysis.CalculatedbytakingarollingstandarddeviationofthepastfiveyearsofGDpgrowth.frenchandGermantimeserieshavetimeseriesgapsduringwartime

�.iNflATioNVolATiliTyiNTheTWeNTieThCeNTUry

1880

1910

1904

1898

1892

1886

1940

1934

1928

1922

1916

1946

1952

1958

1964

1970

1976

1982

1988

1994

2000

2006

50%

25%

30%

35%

40%

45%

0%

5%

10%

15%

20%

France UK GermanyJapan Italy Spain

USSwitzerland Austria Belgium Denmark

Finland Netherlands Norway Sweden Portugal

Source: mitchell(2003),oeCD,oliverWymananalysis.Calculatedbytakingarollingstandarddeviationofthepastfiveyearsofinflationrates


It is also worth noting the extent of regional variation in long-term economic performance. It is widely assumed today that Asian emerging markets will continue to narrow the gap between themselves and the developed economies. One hundred and thirty years ago, a similar forecast might have been made with respect to Japan (see figure 10). In 1874, Britain’s per capita GDP was approximately 4.4 times higher than Japan’s. By 1940, the ratio was down to 2.2:1. yet the disruptive effects of the Second World War set Japan back almost to square one. It was not until the 1960s that convergence returned to its long-run trend-line. There is an important lesson here for those who make projections in the form of smooth lines.

32

10.briTiSh/JApANeSe(1874-1��8)ANDUS/ChiNeSeperCApiTAGDp(2000-2050)

2000

2005

2010

2020

2025

2030

2035

2040

2045

2050

2015

5

5

4

3

2

1

0

1874

1880

1886

1898

1904

1910

1916

1922

1928

1934

1946

1952

1958

1964

1970

1976

1892

1940

1982

1988

1994

25

20

15

10

45

40

35

30

US/China GDP per capita

British/Japanese GDP per capita

0

Source: maddison,A,(2003)

liqUiDiTyANDGlobAliNTeGrATioN

As we have seen, liquidity is generally agreed to be at a very high level today. But what exactly do we mean by liquidity?

Liquidity has been defined in different ways at different times, and a lack of liquidity during a crisis rarely means the same thing twice. We consider liquidity to consist of three measures

Cash, deposits, and money market instruments – measured by “Marshallian K”: the money supply as measured by the monetary aggregates M1, M2, and M3, divided by nominal GDP


real and nominal interest rates – where a lower interest rate implies cheaper money and hence higher liquidity, this being the main measure by which liquidity fell during the summer of 2007

trading activity in markets for financial assets – in terms of volumes traded and bid-ask spreads

Over a century, it is relatively easy to use Marshallian K. By calculating Marshallian K for all of those markets where data are available, we are able to show that liquidity is not currently exceptionally high compared to the last hundred years.

to be sure, the measure produces some counterintuitive results. The wartime and Great Depression periods appeared to experience extremely high liquidity, but this was primarily due to decreased GDP during these periods. even when we exclude these periods, we find that liquidity is still not exceptionally high by historical standards in terms of a narrow monetary measure. Measured using M1, Marshallian K today (0.33) is only just above the 1914 level (0.28). Broader monetary measures, however, do confirm the high liquidity hypothesis. Calculated using M2, Marshallian K was 0.49 in 1914, a level equalled at the end of the Second World War, and currently stands at 0.66 (see figure 11). M3, the measure that includes the largest quantity of financial instruments, has only been tracked over the past 50 years. M3 Marshallian K starts at 0.61 in 1960, rising to 1.07 today. Measured on this basis, liquidity is evidently significantly higher than it used to be.

34

11.mArShAlliANK(liqUiDiTy)iNDeVelopeDCoUNTrieS

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1900

1905

2005

1965

1955

1945

1935

1930

1925

1920

1915

1910

1970

1960

1950

1940

M1, M2 and M3 divided by nominalGDP (weighted global average)

M1 M2 M3

1990

1980

1995

1985

1975

2000

Source: bankofengland,Datastream,mitchell(2003),SwissNationalbank,Carter,Gartner,haines,olmstead,SutchandWright(2006),oliverWymananalysis

The relatively smooth curves of “Marshallian K”, however, hide numerous crises that have arisen over the past century and a half. As shown in Box 1, such crises, sometimes triggered by small events, have the capacity to rapidly suck out liquidity from the system.


box1–AbriefhiSToryofCriSeS,CrASheSANDpANiCS

The following is a brief summary of the triggers and responses to crises in the uS financial markets over the last 150 years.

Trigger Sequence of events Regulatory reaction Loss of confidence in

Pan

ic o

f 1873

1873

-187

6

bankingfirmJayCooke&Co.filesforbankruptcyafterover-investinginrailroads

TheNewyorkStockexchangeclosesfor10days

18,000businessesfailbetween1873and1875,8�ofthecountry’s364railroadseventuallygobankrupt

Unemploymentreaches14%by1876

Treasuryinjects$26mmintoeconomy

presidentGrantandCongress

leadersofbankingandmanufacturing

Pan

ic o

f 1893

18�3

-18�

6

runongoldsupplymeansthatpeoplecannolongerexchangesilvernotes,causingsilverpricetodrop

pricesofothercommoditiesdrop

financialtrustscollapseandWallStreetcomesclosetocrashingasindustrialstocksarehardesthitandrailroadsgobroke

europeanbanksselltheirAmericansecuritiesresultinginbankrunandtheclosureof500banksand15,000companies

ShermanpurchaseActwasrepealed

Treasurynolongerforcedtobuysilverwithnotesredeemableforsilverorgold

presidentClevelandandtheDemocraticparty

Pan

ic o

f 1907

14-3

0o

cto

ber

Speculatorf.A.heinzetriestocornerthestockofUnitedCopperCompanywhichthencollapses,losing$50mm

heinze’sbutteSavingsbankfails

reportsassociatetheKnickerbockerTrustCompanywithheinzewhichclosesaftersufferingarun,payingout$8mmover3hours

TrustCompanyofAmerica’sreputationsimilarlydamagedbyassociationandbarelysurvivesarun;Stockmarketnarrowlyavoidsacrash

financesalsohitbyeuropeaninvestorsreluctanttobuythecity’sbonds

Treasurydeposits$25mminNewyorkCityTrust

Jpmorganpressurestrustcompanypresidentsandbankersintoputtingupfundstosupportailingtrusts

Associatesandassociatedinstitutionsoff.A.heinze

3636


Gre

at

Dep

ress

ion

1�

2�-1

�3�

blackThursday(stockmarketcrash)

exchangefalls12%onTuesday

Smoot-hawleytradebillispassedinJune1�30

GNpfallsby31%whileunemploymentrisesto24%

industrialstocksdown80%;10,000banksfail

Thirdbankpanicoccursinmarch1�33andabankholidayisdeclaredtoavertarunonbanks

rooseveltannouncesplanstoredistributewealthfromrichtopoor

1�3�,DepressionendsworldwideascountriesprepareforWorldWarii

fedcutstheinterestratefrom6%to4%

Taxraisedfrom25%to63%

Congresspassestheemergencybankingbill,theGlass-SteagallActof1�33,andotherlegislation

banks,governments,andregulators

1973 o

il c

risi

s o

cto

ber

1�7

3-m

arch

1�7

4

opeCannouncesembargoonpetroleumexportstocountriessupportingisraelinitsconflictwithSyriaandegypt

opeCannouncesa25%cutinoutputandthreatensafurther5%

priceperbarrelquadruples,gasolinepricesdouble,andNySeshareslose$�7bNin6weeks

SuddeninflationandeconomicrecessionhitindustrialisedcountriessuchasfranceandUS,causingunemployment

energyshortagescausetheclosureofschoolsandmorefactories

embargoisextendedtoportugal,rhodesia,andSouthAfrica

presidentNixonsignstheemergencypetroleumAllocationAct

Westernnations’centralbankscutinterestratestoencouragegrowth,butstagflationresults

embargoliftedmarch1�74

Nationalenergysecurity

Bla

ck M

on

day 1

987

1�

-20

oct

ob

er

UShouseofrepresentativesfileslegislationtoeliminatetaxbenefitsform&As

UStradedeficitforAugustisaboveexpectations

Wednesday14:Tradedeficitreportpushesdollardown.Taxannouncementandriseininterestratesputfurtherpressureonequityprices

monday1�:futuresopenontimewithheavyselling.DJiAandS&p500drop23%.S&p500futuresfall2�%.rumoursofexchangeclosuresparkmoresales.highvolumeoverwhelmssystemandtradesarereportedlate

Tuesday20:fedannouncesitwillsupportfinancialsystem,liftingmarketsentiment,butpreventsarbitragetradersfromusingDoTsystemtotrade.portfolioinsurerssellinfuturesmarket,pushingdownprices.indexarbitragersnotactive,unabletomitigatepressureinthefuturesmarket

fedlowersinterestratesandinjectsliquidity

fedhelpsbanksextendcredittosecuritiesfirms,liberaliseslendingofsecuritiesandstepsupsupervisoryefforts

Circuitbreakersintroduced

Useofcomputersinstockmarketstoengageinarbitrageandportfolioinsurancestrategies



Asi

an

cri

sis

1997

1��7

-1��

�

may14:Thailandspendsbillionsofdollarsofitsforeignreservestodefendthebahtagainstspeculativeattacks

Thaibahthitbyspeculation.CurrencycrisisspreadsthroughSoutheastAsia.Currenciescomeunderpressure,andgovernmentsandcentralbanksresorttoimfaidpackages.hongKongraisesratesto300%toprotectthehKDollar.Chinese,Japanese,andKoreancurrenciescomeunderpressure

russianmarketsaffected:Centralbanktriplesinterestratestoprotectruble;stocksandbondssoaraftertheimfannouncesa$23bNemergencyloanpackageforrussia,butcollapseswhenrussiaofficiallydefaultsondebts

Dowloses300pointsinthird-biggestlossandfallsafurther512pointsfollowingturmoilinrussia.fedcutsinterestrates3timesin7weeksbeforeDowrallies.ConsortiumofUSfinancialinstitutionsprovidesa$3.5bNbail-outtolTCm,fearingcollapsecouldworsenpanic.Stocksfallineurope

latinAmericanstockandbondmarketsplungeonfearsofdefaultanddevaluationinSouthAmericaandglobalcrisis.brazilseeshalfofitsmarketvalueerased,whilemexicoisforcedtodefenditscurrency

Substantialimfbail-outsgiventoaffectedAsiannationsconditionalonaseriesofreforms

Centralbanksacrosstheworldintervenetodefendtheircurrencies

enhancedsurveillancebyimfandincreasedfocusonpreventionofcrises

introductionofinternationalcodesandstandardstoimprovereportingandtransparency

Theimf

ThegoverningpartiesinAsiaandrussia

Do

t co

m b

ub

ble

bu

rst

2001

-200

3

NASDAqpeaksat5,048.62onmarch10

multi-billiondollarsellordersformajorhightechstocks(Cisco,ibm,Delletc)areprocessedsimultaneously,triggeringchainreactionofselling.NASDAqloses�%in3days,fallingfrom5050onmarch10to4580onmarch15

2001,bubble’sdeflationrunningfullspeed.majorityofthedot-comsceasetradingafterusinguptheirventurecapital,oftenwithoutmakinganetprofit

improvementsintheChineseWallconceptarisingfromconflictsofinterest

equityanalysts,forpublishingallegedlydishonestanalysisonfirms

383838


Cre

dit

cru

nch

20

07-

Defaultsonsub-primemortgagesfollowingdropinhouseprices

Defaultingsub-primemortgagescollapseCDos.hedgefundsreportmassivelosses:TwofundsrunbybearStearnslosealloftheir$20bNvalue.housepricescollapseandshort-termcreditmarkets

Worriesaboutthesub-primecrisisandfearsabouthowmanyfinancialfirmsareexposedtotheseproblemshitglobalstocksinUS,london,france,andGermany.marketsremainjitteryasfurtherreportsemergeconcerningsignificantlyreducedthird-quarterprofitsandbail-outsoffinancialinstitutions

TheeuropeanCentralbank(eCb)isforcedtoinject$�5bNeurosintotheeurobankingmarkettoallayfearsaboutacreditcrunch,whilethefedandthebankofJapantakesimilarsteps

eCbloans$130bNtoassuagethecreditcrunch.fedandJapan’scentralbankresorttosimilarmeans

Thebankofenglandresistsbuteventuallyfallsintoline

Thefedcutsfundratesbyhalfapercentagepoint

investmentbankspumpmoneyintofundstoshoreupvalue

Creditratingagencies,whoarecriticisedfornotspottingcompanieswithcreditproblems,andalsodebtbundlesinvolvingsub-primemortgages

3�THE EvoluTion of financial sErvicEs 3�THE EvoluTion of financial sErvicEs

There are, however, other ways of measuring liquidity. Put in the simplest terms, liquidity means the abundance of money. When money is abundant, we would expect that the price of money (the interest rate) would be low. As figure 12 shows, if we take interest rates as a proxy for liquidity over the last hundred years, we find that the levels of liquidity we are witnessing today are by no means extreme. Average real and nominal interest rates were 4.3% and 4.6% prior to 1914, diverging to -1.0% and 5.1% between 1914 and 1989. Since 1989, the averages have been 3.6% and 4.9%.

12.reAlANDNomiNAliNTereSTrATeSiNDeVelopeDCoUNTrieS

1870

1878

1990

1974

1958

1942

1926

1918

1910

1902

1894

1886

1982

1966

1950

1934

-15%

15%

0%

10%

5%

-5%

-10%

-30%

30%

0%

20%

10%

-10%

-20%

2006

1998

Real (right hand side)Nominal (left hand side)

Source: bankofengland,UnitedNations,Nber,GlobalfinancialData.DataisforJapan,UK,france,Germanyanditaly,plusSwitzerland,theUSandSpainandfrom1�07,1�14and1�53respectively

In view of the different definitions of liquidity, we would ideally combine them all into a composite measure of liquidity: a weighted combination of all the liquidity-related factors tracked for this study (including bid-ask spreads and market capitalisations for the years when data are available). This measure (see figure 13) shows liquidity rising during the late nineteenth century, falling and then rising again during the Great Depression and the Second World War – a time when monetary expansion associated with reflationary policies and war finance outpaced growth. Our proprietary liquidity index tended to decline from the end of the Second World War until the period of financial liberalisation in the 1980s and 1990s.10 up until 2000, liquidity was similar to that on the eve of the First World War. Only in the last few years has it risen above that level.

10 TheoliverWymanliquidityvariableconsistsofaweightedcombinationofrealandnominalinterestrates,marshallianKonm1andm2andthemarketcapitalisationofworldstockandbondmarkets.Source:mitchell(2000),oeCDStatisticsDept,UNStatisticsDept,Datastream,Worldfederationofexchanges

4040

13.oliVerWymANliqUiDiTyVAriAbleforSeleCTeCoNomieS

0

10

20

30

40

50

60

70

80

90

100

1900

1907

2005

1991

1977

1963

1949

1942

1935

1928

1921

1914

1998

1984

1970

1956

Global liquidity

Source: mitchell(2003),oeCDStatisticsDept,UnitedNations,Datastream,Worldfederationofexchanges,oliverWymananalysis

Similarly, we would do well not to exaggerate the novelty of contemporary levels of globalisation.

The last age of globalization (from the 1870s to 1914) was similar to our own in at least five ways. First, it was characterized by relatively free trade, limited restrictions on migration and hardly any regulation of capital flows. Second, inflation was low and growth relatively stable. Third, there was a wave of technological innovation that revolutionized the communications and energy sectors; among other things, the world discovered the joys of cables, wirelesses, the internal combustion engine and tarmac. Fourth, the American economy was the biggest in the world and the development of its massive internal market became the principal source of business innovation. Fifth, China was opening up, raising all kinds of expectations in the West. russia was growing rapidly too.

But after 1914 world markets were disrupted and disconnected, first by economic warfare, then by post-war protectionism. Prices went haywire – indeed, a number of major economies suffered both hyperinflation and steep deflation in the space of a decade. Although technological and managerial innovation did not stop, the American economy ceased to be the most dynamic in the world; it faltered during the war, overheated in the 1920s and languished throughout the 1930s in the doldrums of depression. China succumbed to civil war and foreign invasion, defaulting on its debts and disappointing Sino-optimists in the West. russia suffered revolution, civil war, tyranny and foreign invasion. Both these giants responded to the mid-century crisis by donning the constricting armour of state socialism. In this they were not alone.

41THE EvoluTion of financial sErvicEs 41THE EvoluTion of financial sErvicEs 41THE EvoluTion of financial sErvicEs

Periods of hyperinflation, now unheard of in the developed world hit several european economies during the early twentieth century. Germany suffered two complete currency collapses within less than thirty years. By the end of the 1940s nearly every government in the world, including those that retained political freedoms, imposed restrictions on trade, migration and investment as a matter of course. Some achieved autarky, the ideal of a de-globalized world. Consciously or unconsciously, all were applying in peacetime the economic restrictions that had first been imposed between 1914 and 1918.

Only slowly after 1945 were these distortions removed. trade was liberalized well ahead of capital movements; under the Bretton Woods system, most countries retained capital and exchange controls. Banking systems were tightly regulated, where they were not directly state-owned. It was not until after the Great Inflation of the 1970s that the environment became more benign for financial services, beginning with the breakdown of fixed exchange rates and the deregulation of the British and American financial systems in the 1980s and 1990s.

It is true that there have been great advances in trade liberalization since the 1940s. As a proportion of GDP, however, trade has not reached unprecedented heights. In the developed world, trade was equal to roughly 20% of GDP from 1880 to 1914, reaching a low of ~10% in the middle of the 20th century, and not rising above 20% again until 1999 (figure 14). World trade declined so steeply in relation to global output during the war-torn middle of the last century that the period after 1945 was mainly about regaining the previous height of global integration. In terms of the relative importance of trade, in other words, we are living through Globalisation 2.0. The clear lesson of history is that the process of globalisation can be reversed, no matter how far it has advanced.

42

14.imporTSANDexporTSfromSeleCTeDDeVelopeDeCoNomieSASAproporTioNofGDp

-40

30

-10

20

10

-20

-30

1870

1879

1987

1969

1951

1933

1924

1915

1906

1897

1888

1996

1978

1960

1942

2005

0

ExportsImports

Trade as % of GDP

Source: mitchell(2003),oeCDStatisticsDept,UnitedNations,oliverWymananalysis.Countriesincluded:france,Germany,UKanditaly1870-2006,Japan1885-2006,Spain1�00-2006,DenmarkandNetherlands1�13-2006,NorwayandSweden1�15-2006,belgium1�1�-2006,Austria1�2�-2006,Switzerland1�2�-2006,portugal1�50-2006,US1�60-2006andfinland1�71-2006

International financial markets have evinced a similar pattern. Cross-border capital market integration lost significant ground during the mid twentieth century, only recently exceeding the levels seen in the early 1900s. One way of illustrating this point is by measuring the differences in sovereign bond yields across markets both in terms of absolute differences and taking into account changes in the exchange rate between two markets. using spot rates and three-month forward rates between two markets as well as the yield on three-month treasury bills, we are able to determine the difference in expected yield in a unit of currency invested at the same time in two different countries, and hence the degree of capital mobility between them (assuming that there is no credit or transfer risk associated with the securities). Where a gap exists between the expected return on, for instance, a dollar invested in new york compared with a dollar invested in London at the same time over the same period, an arbitrage opportunity is created. Assuming perfect capital mobility, traders should quickly take advantage of this opportunity, thereby eliminating the gap. The average size of this arbitrage gap between the uS and the uK and between Germany and the uK was just 0.28% between 1870 and 1914, rising to 1.1%11 from 1914 to 1945, and 1.0% from 1945 to 1985, before falling again to 0.1% (see figure 15).

11 Thisfigureexcludesthe1�22UK-Germanyfigurewhichwas�7%


15.ArbiTrAGeGApoNThreemoNThSoVereiGNDebTbeTWeeNUSANDUK,GermANyANDUK

4.0%

0.0%

3.5%

3.0%

2.5%

2.0%

1.0%

1.5%

1870

1905

1898

1891

1884

1877

1912

1947

1940

1933

1926

1919

1954

1989

1982

1975

1968

1961

1996

US to UK SD Germany to UK SD

Source: obstfeldandTaylor(2002)

In short, it would be a mistake to regard the past ten years as exceptional in terms of liquidity or global integration. We have been here before – in the first age of globalisation before 1914 – and history makes it clear that both liquidity and globalisation are capable of ebbing even more rapidly than they flow. The global environment cannot be counted on to remain as benign as it has been over the past decade.

DemoGrAphiCTreNDS

The demographics of the developed world have certainly changed quite dramatically over the past century as a result of improved life expectancy and reduced fertility. From the perspective of a century of history, however, there is nothing so very remarkable about the current and projected increase in dependency ratios. Overall, in fact, the dependency ratio has fallen from 38% in 1890 to 33% (see figure 16). What has changed is the composition of the dependent population. today around 16% of the developed world’s population is over 65, compared with just 5% in 1890, when the majority of dependents were children. The problem is that retirees cost up to two-thirds more than children to care for, mainly because healthcare for the old and decrepit is more expensive than education for the young and fit.

44

under the welfare systems set up in the middle of the twentieth century, expanded in the 1960s, and only partially reformed in the 1980s, men and women often leave the labour force before they have ceased to be fit for work. All over the developed world, public and private pension schemes are already coming under strain for this reason. But simply raising retirement ages cannot be regarded as a panacea. It is far from clear that employers want to retain workers in their late sixties and seventies, not least because mental deterioration often precedes physical deterioration.

16.DemoGrAphiCChANGeofSeleCTeDDeVelopeDCoUNTrieS

100%

80%

60%

40%

20%

0%

1890

1920

1914

1908

1902

1896

1926

1956

1950

1944

1938

1932

1962

1992

1986

1980

1974

1968

1998

2004

40%

38%

34%

32%

30%

Age 0 – 14 Age 15 – 64 Age 65+ Dependency ratio (right hand scale)

Source: mitchell(2003),liesner(1�8�),USCensusbureau,UKNationalStatistics,UnitedNations.CountriesincludedareUS,Japan,UK,Spain,italy,Germany,franceandSwitzerland.

GlobAlimbAlANCeS

There is nothing new about large current account deficits and surpluses either. A hundred years ago, the uK ran very large current account surpluses. British savings (and the returns on past overseas investments) were channelled abroad on a huge scale, with a substantial portion going to the country’s imperial possessions. This was part of a large-scale flow of resources from Western europe to the rest of the world, including the uS (which didn’t begin to export capital on a significant scale until the early twentieth century). By 1914, the gross nominal value of Britain’s stock of capital invested abroad was £3.8 Bn, between two-fifths and a half of all foreign-owned assets. Between 1870 and 1913 Britain ran a current account surplus that averaged around 4.5% of GDP, rising above 7% at cyclical peaks in 1872, 1890, and 1913. In modern parlance, there was a “sterling carry trade,” as uK investors sought higher returns in overseas securities than they could achieve at home.


From an accounting standpoint, British surpluses had to be matched by deficits in recipient countries. until the end of the nineteenth century, the uS was the biggest net capital importer. Subsequently, the British colonies of white settlement, as well as Argentina and Brazil, emerged as major destinations for British capital.

By our standards, then, there clearly was some kind of “global imbalance” that allowed Britain to play such a dominant role in international capital flows. to contemporaries, however, this seemed like a stable disequilibrium, if not an age of equipoise.

oVerVieW

The defining feature of the twentieth century is the extent to which the world economy stagnated at the mid-point, regaining the peaks scaled prior to the First World War only in its later years. The key point is that the trend of macroeconomic change is neither linear nor evenly cyclical. History suggests that financial developments are characterised by punctuated equilibria. Projecting forward relatively recent trends must therefore be regarded with great caution need a better framework to make sense of very recent events.

4646

3 OF CyCLeS, SurGeS AnD SPASMS

A longer-term view of the history of financial services underlines the danger of projecting forward the trends of the past ten years. Financial innovation has come in surges rather than as a steady stream. Financial services organisations have undergone a number of major evolutionary changes – most obviously in the nature of banks – and there have been many mutations in ownership and governance. new types of financial institutions have proliferated.

TheloNGrUNofiNNoVATioN

There is nothing new about technologically driven improvements in the efficiency of financial services. A hundred and fifty years ago, the bulk of communications between financial institutions and their clients were handwritten on paper. Only gradually, as the telegraph network spread around the world, did cables or telegrams replace letters. The introduction of the telephone to banking was also a gradual process, as was the adoption of the ticker tape as a means of rapidly disseminating changes in stock market prices. It is easy to forget how recently the new york Stock exchange floor was carpeted with pieces of paper at the end of the trading day.

In this context, the introduction of the desktop computer and basic spreadsheet was less revolutionary than is often assumed. It is true that AtMs reduced significantly the number of bank branch staff required and made employees into generalists, dealing with all types of customer need. But these innovations were spread over a longer period than is generally realised. The first AtM was introduced in 1967 – forty years ago – and the first desktop spreadsheet application in 1979. As figure 17 shows, improvements in productivity in financial services were minimal in the uS before the 1950s, but were then sustained, with only minimal reverses, until the 1990s. revenue per employee hour has risen from $42 in 1934 to close to $200 today. In Switzerland, revenue per employee hour rose from CHF 30 in 1938 to CHF 220 today, with a sharper acceleration in the past twenty years. The difference probably reflects the greater economies of scale possible in the uS in the period after the Second World War.

In each case, the process of technological “mutation” led to significant improvements in commercial banking productivity only quite recently. The possibility cannot be discounted that we may now be on the threshold of another plateau, most of the benefits of computerization having already been achieved.


17.CommerCiAlbANKiNGproDUCTiViTyiNTheUSANDSWiTzerlAND19

34

1938

1942

1950

1954

1958

1962

1966

1970

1974

1982

1986

1990

1994

1998

2002

2006

1946

1978

1934

1938

1942

1950

1954

1958

1962

1966

1970

1974

1982

1986

1990

1994

1998

2002

1946

1978

Number of commercial banks Productivity (interest income/man hour)

Productivity (total income/man hour)

250

200

150

100

50

0

250

200

150

100

50

0

16,000

14,000

12,000

10,000

8,000

6,000

4,000

2,000

0

220200180160140120100806040200

Switzerland

Number of insuredcommercial banks

Revenue per employeehour (CHF)

US

Revenue per employeehour ($)

Number of insuredcommercial banks

Source: fDiC,SwissNationalbank,oliverWymananalysis.employeehoursarecalculatedas8hoursperdayfor230daysperyear

TheSTrUCTUreoffiNANCiAlSerViCeSoVerThelAST150yeArS

The ebb and flow of liquidity and of global integration have been the crucial environmental factors in the history of financial services. The twentieth century witnessed a dramatic rise, fall and revival of the industry, each stage of which was closely correlated to a change in the macroeconomic environment. In developed countries, banking assets as a percentage of GDP hit a peak of 113% in 1914 which was not regained (apart from during the extraordinarily low GDP levels of the Great Depression) until the 1960s, and not meaningfully overtaken until the late 1980s (figure 18). The World Wars and the Great Depression held back the financial services sector to such an extent that only in the last twenty years has it been breaking new

48

ground in terms of its relative economic importance. Deposits as a proportion of GDP stood at 66% in 1914, a level that was not exceeded in the second half of the twentieth century until 1987. today, banking assets as a percentage of GDP stand at 154% compared with 77% for deposits. Deposits have risen considerably more slowly than assets, as individuals today choose to place more of their wealth in mutual funds and other savings vehicles rather than in traditional bank accounts. The ratio of assets to deposits today is 2, compared to 1.7 in 1914.

18.bANKiNGASSeTSASAperCeNTAGeofGDp

0%

50%

100%

150%

200%

1900

1910

1955

1925

1920

1915

1930

1935

1940

1945

1950

1960

1965

1980

1975

1970

1985

1990

1995

2000

2005

1905

WorldWar I

1929crash

WorldWar II

Assets Deposits

Source: mitchell(2003),fraser,fDiC,CUNA,oTS,bbA,oeCD,Sheppard(1�71),pohl(1�82),Goldsmith(1�83),StatisticsbureauandStatisticalresearchandTraininginstituteofJapan,SwissNationalbank,bancodeespana,Thebundesbank,TheShinkinbanksresearchCentre,oliverWymananalysis

Note: Assetsincludescommercial,savingsandcooperative/mutualbankassets.Depositsincludecommercialandsavingsbankdepositsonly

A rather different picture emerges in the case of insurance, which has seen a more sustained long-run expansion in terms of assets and premiums. As figure 19 shows, in 2000 premiums approached 10% of GDP, up from just 1% in 1880 and 5% as recently as the early 1980s. This difference partly reflects the relatively low penetration of insurance during the nineteenth century. However, it is also due to the increasing tendency for individuals to hold their wealth not in bank deposits but in cash-value insurance and insurer-provided annuities of various kinds, as well as in new investment vehicles such as mutual funds.

48


1�.iNSUrANCepremiUmSASAperCeNTAGeofGDp

12%

0%

2%

4%

6%

8%

10%

1880

1888

1924

1900

1896

1892

1904

1908

1912

1916

1920

1928

1932

1968

1944

1940

1936

1948

1952

1956

1960

1964

1972

1976

1988

1984

1980

1992

1996

2000

2004

1884

WorldWar I

1929crash

WorldWar II

Source: Sheppard(1�71),mitchell(1�88),GreatbritainboardofTrade,AnnualAbstractofStatistics,oeCD,insuranceStatisticsyearbook,oliverWymananalysis

If we think of the structural development of the financial services industry in the developed world as an evolutionary process, we can see at work the forces of

Competition and natural selection of those organizations with traits best suited to the slowly changing macroeconomic environment

exogenous shocks in the form of financial crises, ranging from the huge disruptions of the Great Depression and World Wars to the smaller crises of more recent times

Over the course of the past century, the populations of different species within the industry have grown, shrunk, and on occasion become extinct as a result of these interacting forces

Figures 20 and 21 track the evolution of retail and commercial banking, investment banking and fund management and insurance – the three main “phyla” within the financial services sector. The thickness of each bar is intended to be roughly illustrative of the relative size and importance of that particular species in terms of the number of firms, their assets and revenues.

50

20.TheeVolUTioNofreTAilANDCommerCiAlbANKiNG

Internet/direct banks

1900 1925 1950 1975 2000 2007

Telephone/direct banks

Shareholder-ownedprivate banks

High-end private andmerchant banks

Commercial banks

Full service retail andcommercial banks

Subsidiaries of majorconglomerates

Shareholder ownedsavings and loans

Not for profit savingsand loans

Government owneddeposit takers

Bancassurance

Monoline consumerfinance and mortgage

An example of the movements in the competitive landscape described in figure 20 is the emergence and retreat of bancassurance. This particular branch of retail banking evolved as a push by retail banks to leverage their branch networks in the distribution of non-traditional retail banking products – namely, in this case, insurance. The merging of banks and insurers was largely a response to looser financial services regulation, though the model later turned out to be less successful than many had hoped, and bancassurance franchises became absorbed by universal, or full service, commercial banking organisations.

It is often assumed that the most important trend in retail and commercial banking has been towards consolidation. However, figure 20 makes it clear that considerable “bio-diversity” remains. north America and to a lesser extent some european markets still have highly fragmented retail banking sectors. The cooperative banking sector has seen the most change, with high levels of consolidation (especially following the Savings and Loans crisis of the 1980s and similar events in other markets), and most institutions moving to shareholder ownership. But the only species that is now close to extinction in the developed world is the state-owned bank. Government ownership of banking organisations – very prevalent in some countries from the 1940s until the early 1980s – has declined steeply as a result of privatisation (but see below for a new manifestation of state ownership in the realm of investment management).


In other respects, the story is one of speciation – the proliferation of new types of financial institution – which is what we would expect in a truly evolutionary system. Many new monoline financial services firms have emerged in the commercial banking space, especially in consumer finance. For example, MBnA, established in 1982 as a subsidiary of Maryland national Bank, survived as an independent company from the time it was spun off in 1991 until 2005, when it was acquired by Bank of America. Other companies, such as Capital One, have remained independent, though many of these experienced difficulties during the credit crunch of August-September 2007.

A number of new “boutiques” now exist to cater to the private banking market. Direct banking (telephone and Internet) is another relatively recent and growing phenomenon throughout the developed world. Branch networks have been bypassed for simple deposit-taking organisations, and even traditional non-direct banks are trying to reduce customer ”footfall” in branches by offering more and more services online.

21.TheeVolUTioNofiNVeSTmeNTbANKiNGANDiNVeSTmeNTmANAGemeNT

Boutique/specialistinvestment banks

1900 1925 1950 1975 2000 2007

Universal bankdivision

Shareholder ownedinvestment banks

Private ownedmerchant banks

Boutique investmentmanagers

Alternative investment managers

Private equity houses

Marketplace/exchange

52

Alternative investment houses specialising in hedge funds, private equity or even both have been a relatively recent phenomenon, though both have existed in some form for many decades. The resurgence of specialist investment banking organisations has also been a recent trend, with an increasing number of small boutique shops competing alongside the global bulge bracket firms. Modern investment management has evolved in a similar way in the course of the twentieth century. There has been a trend towards consolidation, in the sense that publicly quoted investment banks have absorbed a substantial number of privately owned merchant banks, stock-brokers, and other entities since “Big Bang” in London (see Box 2). universal banks in the German tradition have gained in importance in this sector as regulations have eased, particularly following the 1999 repeal of the American Glass-Steagall Act, passed in 1933 to separate retail and investment banking.


box2–loNDoN’SbiGbANG

The “Big Bang” in London in 1986 was complex legislation deregulating the financial markets, including the removal of the distinction between stockjobbers (market makers) and stockbrokers. The resulting fallout was the rapid demise of an entire species of firm, as all the city’s stockjobbers were acquired by either banks or stockbrokers. Since the Big Bang, London’s presence on the world financial stage has changed dramatically. The City is now the dominant financial centre in europe, and on some measures, the world.

The stockjobbers were run as cliquey old boys clubs with little exposure to international competition. today, the market makers all sit within banks, most of which are not of uK origin.

SToCKJobberS–WhereAreTheyNoW?

Name What happened?

Akroyd&Smithers boughtbySGWarburg(subsequentlyacquiredbyUbS)

WeddDurlachermordaunt purchasedbybarclays

pinchinDenny boughtandeventuallyclosedbymorganGrenfell(nowpartofDb)

Smithbrothers becameSmithNewCourtbeforebeingpurchasedbymerrilllynch

bisgoodbishop boughtbyCountyNatwest(subsequentlyboughtbySSb)

Charlesworth partofKleinwortbenson

loNDoNreborNASANiNTerNATioNAlfiNANCiAlCeNTre

Measure* 1986 2005

DomesticequitiesannualturnoverlSe(£bN) 161 2,4�5

foreignequitieslistedonlSe 0 2,703

foreignexchangedailyturnover($bN) 50 1,210

UKprivateequityassets(%ofeuropeantotal) 33.�% 66.7%

UKprivateequityfundraising($mm) 360 46,170

*Thomsonfinancial,ifSl,londonStockexchange,bankofengland

54

The total number of banks in developed countries peaked at the beginning of the 1920s (see figure 22). Subsequently, a wave of failures in the uS and europe during the Great Depression reduced the total number of banks by a third in a little over a decade. Since the mid 1980s, there has been a prolonged period of banking consolidation across all economies, driven by regulatory changes, the pursuit of economies of scale, and improvements in systems and technology. The trend of de-mutualisation has also reduced the number of mutual and cooperative banks by more than half in just twenty years.

22.NUmberoffiNANCiAliNSTiTUTioNSiNSeleCTeDDeVelopeDCoUNTrieS

80,000

70,000

60,000

50,000

40,000

20,000

10,000

30,000

0

1900

1920

1916

1912

1908

1904

1924

1944

1940

1936

1932

1928

1948

1968

1964

1960

1956

1952

1972

1980

1984

2000

1996

1992

1988

2004

Commercial Banks Saving Banks Mutual & Cooperative Banks

Mutual funds Hedge funds

1976

Source: oeCD,bundesbank,Davies(2002),mura(1��6),Duet(1�86),bátiz-lazo(2004),Sheppard(1�71),pohl(1�82),Torgerson(1�54),Schiffer(1�62),oliverWymananalysis.CountriesincludedaretheUS,Japan,UK,Switzerland,Spain,italy,franceandGermany

As the number of banking organisations has been falling, however, the aggregate value of the industry has been rising, from just $1 Bn in 1890 in the markets of the developed world to roughly $5 tn today (figure 22). The expansion of American banks has been an important factor in this story. In 1965, just thirteen uS banks had a total of about 200 foreign branches. By 1987, the numbers had risen to about 200 banks with around 800 branches. As early as 1970 the deposits of uS banks with branches in Britain exceeded those of the uK clearing banks.

yet, as figure 22 makes clear, financial evolution is not primarily a story of concentration but of speciation: with new forms of services and institutions emerging to take advantage of subtle changes in the economic environment.


23.eSTimATeDVAlUeofThefiNANCiAlSerViCeSSeCToriNDeVelopeDeCoNomieS

10,000

1,000

100

10

1

1,000

100

10

1

0

1890

1897

1904

1911

1918

1939

1932

1925

2002

1995

1988

1981

1974

1967

1960

1953

1946

Industry value ($BN) Average firm value ($MM)

Average firm valueIndustry value

Source: frASer,oeCD,Datastream,oliverWymananalysis

even as giants have formed in the realm of investment banking, new and nimbler species of investment vehicles – such as hedge funds and private equity partnerships – have evolved and proliferated. Although the first hedge fund was established as long ago as 1949 (by the Columbia university sociologist Alfred Winslow Jones), their emergence as major players in global financial markets is a relatively recent phenomenon. In 1992, the SeC counted a mere 400 hedge funds with just $50 Bn of assets under management.12 By the end of 2006, the number had increased more than twenty-fold and assets under management by a factor of nearly thirty. As of the second quarter of 2007 there were 9,767 funds with $1.74 tn of assets under management, somewhat less than a tenth of the assets under management by, respectively, pension funds ($21.6 tn), mutual funds ($19.3 tn), and insurance companies ($18.5 tn).13

Because they do not come under the aegis of the Investment Company Act of 1940, hedge funds are able to pursue multiple investment strategies. At the time of writing, there were at least seventeen distinct hedge fund strategies, ranging from convertible arbitrage to short selling.14 The ability of hedge funds to leverage their positions greatly magnifies their share of global financial market activity. The estimated gross investments of the five largest hedge funds amount to around $100 Bn. For the sector as whole the figure is $6 tn. They now account for between a third and a half of all in trading in the uS and uK equity and bond markets.15

12 SecuritiesexchangeCommission(1��).

13 hedgefundresearch,“AlternativeinvestmentindustryperformanceandTrends”(2007)

14 Ackermann,mcenally,andravenscraft(1��).

15 mcKinseyGlobalinstitute(2007),pp.10-14

56

There has been a somewhat smaller surge in the number of private equity partnerships and the assets they manage, taking the total for assets to $710 Bn at the end of 2006. Most recently, there has been significant innovation within these new species, with several funds (i.e. Fortress) running multiple business lines. Others, such as Bain Capital and Monitor Clipper, have established partnerships with strategy consultancies.

Sovereign wealth funds are also playing an increasingly important role in the realm of investment. even as the state has retreated from banking in most markets, the rapidly accruing hard currency reserves of manufactured goods exporters and energy exporters are producing a new generation of sovereign wealth funds.

One estimate for the total assets under management by hedge funds, private equity, sovereign wealth funds and central banks is $8.7 tn. By 2012, the figure could be as high as $15.2 tn.16

Banking, then has undergone a profound transformation. usually innovation (“mutation”) has been an evolved response to the environment and competition, with natural selection determining which new traits become widely disseminated. Sometimes, however, this process has been accelerated or disrupted by major financial or regulatory shocks. The Great Depression of the 1930s and the Great Inflation of the 1970s stand out as times of major discontinuity, with “mass extinctions” such as the bank panics during the Depression and the Savings and Loans crises in the 70s.

Could something similar happen in our time? The most famous hedge fund crisis to date affected just one firm (Long term Capital Management) in 1998. There was a lesser-known crisis in the 1960s when poorly hedged, highly leveraged positions unravelled fast, reducing the number of funds from 200 to less than a quarter of that number. In January 1989, there were just 143 hedge funds in existence. Between 1989 and 1996 1,308 new funds were formed. Of the total number of funds, 533 ceased to exist by the end of 1996, an attrition rate of just under 37%.17

The sharp change in credit conditions in the summer of 2007 created acute problems for certain hedge fund strategies (quantitative and long/short especially), leaving them vulnerable to redemptions by investors and/or absorption by investment banks. Another important feature of the recent credit crunch has been the pressure on investment banks to bring other kinds of relatively novel organisms (conduits and SIvs) back on to their balance sheets. Both trends seem certain to reduce the number of these entities within the next quarter, though there is clearly no danger of outright extinction.

16 ibid.,p.12

17 managedAccountsreports


even so, the long-run trend is very different from that predicted a century ago by socialist critics of “finance capitalism” like rudolf Hilferding, who assumed an inexorable movement towards more concentration of ownership. As in the natural world, the emergence of hungry giants does not preclude the evolution and continued existence of smaller species. Size isn’t everything, in finance as in nature. Indeed, the very difficulties that arise as publicly owned firms become larger and more complex – the diseconomies of scale associated with bureaucracy, the pressures associated with quarterly reporting – make it very probable that new kinds of private firm will flourish. What matters in evolution is not your size nor your complexity, though evolution may have led you to become both big and complicated. All that matters is that you are good at surviving and reproducing your genes. The financial equivalent is being good at generating returns on equity and generating imitators employing a similar business model. Both are easier for small firms.

24.TheeVolUTioNofiNSUrANCe

Mutual life insurer

1900 1925 1950 1975 2000 2007

For profit life insurer

Integrated insurer

Bancassurance

Non-life insurer

Mutual health insurer

For profit health

insurer

Reinsurance

Marketplace/exchange

A parallel can be drawn between figure 24 and figure 20, both of which track the emergence and retreat of bancassurance. Firms were picked up from the insurance industry by banking organisations before, in many cases, remerging with insurance companies as ventures proved less successful than expected. Mutual insurers are a species that can be seen in figure 24 to be waning. As market share has been picked up

58 58

by for profit enterprises, the need for mutual insurers has diminished and many have either become, merged with or been acquired by for profit insurers. The modern history of insurance also tends to be thought of as a story of concentration and consolidation, with the emergence of a small number of giant global players. Here too, however, the more important trend is towards diversity. true, the global reach of the world’s largest insurers has increased in the last few decades, a trend dating back to the beginning of the twentieth century when companies such as Prudential (uK) began expanding overseas. yet the emergence of for-profit health insurers provides further evidence of the importance of speciation in the long run.


box3–loNG-TermANDCyCliCAlGroWTh

While the banking sector has enjoyed strong real growth rates for the past ten years, much of this is unusual in relation to longer-term twentieth century trends. The chart below indicates whether the change in financial services value relative to GDP growth over the same period has been running above or below expectations based on trend lines. examining the long-term growth trend of financial services value and its relationship to underlying GDP in the countries in which it operates, we can determine whether for any period of time the change in value has been running above or below trend, relative to the growth of GDP over the same period. The period 1980-2003 stands out in terms of the divergence of real and expected growth rates, with financial services currently growing at ~4% above trend. The 1914-1945 period was characterised by war, inflation, and depression, leading to low real growth. The more recent 1946-1979 period, characterised by high inflation and unstable markets, exhibited real growth of 5%, only just above the long-term average. The period 1873-1913 exhibited above-average real growth, though not nearly so detached from the drivers as today.

reAlANDexpeCTeDGroWThiNTheVAlUeofThebANKiNGSeCTor1873-2003

1%

2%

3%

4%

5%

6%

7%

8%

9%

0%1873-1913 1914-1945 1946-1979 1980-2003

Actual Expected

Within each time frame examined, the business cycle has also played a role in the changes in value of the industry. Growth from 1995 to 2000, for instance, ran well above trend at 15% annually in real terms. Similar periods can be identified throughout the last 150 years.

60

oWNerShip

Figures 20, 21 and 24 highlight several distinct trends in the ownership of financial services. early in the twentieth century, nationalised banking sectors were rare. In the middle of the twentieth century, by contrast, there was a surge of public ownership, most obviously in Central and eastern europe. The banking system was nationalised in India in 1969. The biggest French banks suffered a similar fate in 1981. The most recent trend (see figure 25) has been towards privatisation (technically the sale of state-owned equity to the public), though there remain some state-owned banks in Western europe (such as the German Landesbanken and individual institutions like Sweden’s soon to be privatised SBAB). Developing countries still have far greater proportions of state-owned banks, with China and India the two most obvious examples. State-run banks have tended to lag behind their private sector counterparts. In 2000, for example, non-performing loans at Chinese state banks equalled 18% of the total.18

25.NUmberoffiNANCiAlSerViCeSpriVATiSATioNSANNUAllyiNeUrope

25

0

20

15

10

5

2003

1996

1998

2000

2002

1997

1999

2001

2005

1985

1986

1987

1988

1989

1990

2004

1991

1992

1993

1994

1995

2006

2007

Number of privatisations

Source: privatisationbarometer.Coversallcountriesineurope

even as state-owned banks have declined in importance, many privately owned banks have moved towards public ownership through stock market listings or sales to already listed institutions. Allowing banks to become joint-stock companies enables them to acquire much larger capital bases.

There are notable exceptions to this trend, however. Some smaller firms such as boutique investment banks and niche private banks have remained as partnerships or otherwise privately (sometimes family) owned. For other small financial services companies, such as hedge funds and private equity firms, private ownership has been

18 Nicholaslardy,instituteforinternationaleconomics


the norm for decades, with only a handful of the bigger players recently electing to list on stock markets and sell equity stakes to the public.

The emergence of private equity and other activist investors is not a new phenomenon, it should be noted. Indeed, if we look back a century, it represents a return to the days of purer capitalism. Whether this will be a cyclical blip or a fundamental shift in corporate ownership and governance will not be clear for some time.

One of the forces driving the creation of “private capital” providers is producer compensation. The whole of financial services can be thought of as having three factors of production: human talent, financial capital, and infrastructure/technology. Over time, the importance of each of these ebbs and flows with the market environment, and hence the price of each oscillates. At some points in time, such as the private banking boom of the early twentieth century and the private equity boom of the eighties, talented individuals can get much higher compensation by taking slightly more risk and setting up their own businesses outside established firms.

Are hedge funds and private equity partnerships the mammals in our evolutionary analogy, waiting to inherit the earth when the dinosaurs fall victim to severe change in the financial environment? Perhaps. At the moment, however, the relationship between small and large entities is more symbiotic than competitive – a case of “co-evolution” in action. Where, after all, would the hedge funds be without their prime brokers?

In evolutionary terms, then, the financial services sector appears to be in the midst of a kind of “Cambrian explosion”, with existing species flourishing and new species (like hedge funds and private equity partnerships) increasing in number.

TheGeoGrAphyoffiNANCiAleVolUTioN

Despite the differences among economies in terms of regulatory environments and cultures, most can be shown to exhibit broadly similar trends in the emergence of financial services organisations. The growth of investment companies, the penetration of investment banking, the demutualisation of life insurance and savings firms, and the evolution of alternative investment firms have occurred in many different countries at different times.

If we accept that different countries will tend to evolve along similar but not identical paths – which seems an obvious lesson of financial history – then it is possible to see a pattern in the evolution of financial services. Financial intermediation does seem to correlate quite closely to economic growth, even if the causal relationship remains a subject for debate.19 Personal wealth, the main driver of change in financial services, is growing rapidly in the world’s developing economies. A wealthy middle class is

1� Seee.g.Syllaandrousseau(2003).

62

emerging that demands an increasing range of choice and level of sophistication in financial services products. At the same time, the poor are beginning to use products like microfinance loans, deposit accounts and mobile phone payment systems.

An examination of the current penetration of financial services within the world’s economies gives us a rough proxy for financial services’ sophistication and development. Figures for deposits per capita show us the relative penetration of financial services, while GDP per capita gives a proxy for the wealth of the population (see figure 26). The size and wealth of the middle and upper classes, those who use financial services more and with greater sophistication, are harder to quantify.

26.fiNANCiAlASSeTSASAperCeNTAGeofToTAlWeAlThANDGDpperCApiTA

80%

100 1,000 100,00010,000

10%

20%

30%

40%

0%

60%

70%

50%

Czech Republic

China

India Russia

US

UK

France

GermanyItaly

Spain

Japan

HungaryBulgaria

South Africa

Canada

Norway

South Korea

GDP per capita ($)

Nascent Emerging Advanced

Financial assets as a % of wealth

Source: UnitedNations,oeCD,fDiC,people’sbankofChina,oliverWymananalysis

If we group economies according to their level of financial services penetration, we can broadly identify three groups of markets

Nascent markets are those with very low penetration of financial services. Large portions of the population in such economies still do not have a bank account and use only the most basic financial services


Emerging markets are those with a strong retail and business banking sector, high insurance penetration and fast-growing demand for investment products, insurance-wrapped savings, and investment banking products

Advanced economies are those with a mature financial services industry experiencing fast growth in only the most sophisticated and innovative areas – pioneering investment banking products (derivatives, structured products etc.) and complex investment vehicles and asset classes, including private equity and hedge funds

One example of the tremendous growth currently being witnessed in developing markets is the Industrial and Commercial Bank of China, which added more than seven million internet banking customers and 200,000 corporate customers in the first half of 2007, increases of ~50% year over year.20 Investment funds are simultaneously becoming very popular in China, with demand fuelling massive growth in any fund sold through a Chinese retail bank.

The aggregate effect of these changes is to reshape the financial geography of the world. As emerging markets grow, new financial services hubs are emerging to complement and compete against the existing financial centres in the developed world. Long-established centres such as Hong Kong and Singapore are growing rapidly as the markets around them expand. new hubs like Dubai are also emerging in the states surrounding the Persian Gulf, capitalising on regional wealth and demand for emerging product sets such as Islamic finance (including takaful insurance, Islamic financing including sukuks, investment products, and Islamic retail and corporate banking).

At the same time, it is striking to note that capital adequacy of banks in the developed world has been on a slow decline. In europe, capital is now equivalent to less than 10% of assets, compared to ~25% towards the beginning of the twentieth century (see figure 27). Much of this is attributed to the increasing diversification, in terms of both sector and geography, of the asset base of developed economy banks. The question remains how far banks in the developed world have the resources to withstand a period of reduced liquidity (in some segments of the financial system) and of increased competition from emerging markets. In other words, having evolved in such a way as to minimise the ratio of capital to assets, are european banks going to be vulnerable to a harsher macroeconomic environment in the wake of the credit crunch?

20 South China Morning Post,“iCbCdraws30.7monlineclients”,17July2007

64

27.CApiTAlASAperCeNTAGeofASSeTSiNeUropeANbANKS

5%

10%

15%

20%

25%

0%

1900

1903

1909

1915

1921

1927

1933

1939

1945

1951

1957

1963

1969

1975

1981

1987

1990

1993

1906

1912

1918

1924

1930

1936

1942

1948

1954

1960

1966

1972

1978

1984

Source: beninkandbenshon(2002)

oVerVieW

The last century, in summary, has been characterised by relatively benign climates at the beginning and end, and a period of prolonged interruption which started in 1914 and did not die down until the 1980s. Though the drivers and effects changed over time, from war to recession to simply a lack of growth or integration, or even a combination of the three, the defining characteristic was disruption. The impact on financial services firms was severe. Borders were closed and capital flows stemmed by exchange controls or rendered impossible by war. This collapse of the international economy reduced the demand for financial services disproportionately compared to other sectors. Stock exchanges were closed for periods of time which today are almost unimaginable – the new york Stock exchange closed for almost six months at the beginning of the First World War, the only multi-day closure during the past twenty years having been in the wake of 9/11.

This survey of a century of trends in financial services highlights its similarity with an evolutionary eco-system – neither develops smoothly and both are susceptible to long-dated cycles as well as sudden proliferation surges and extinction spasms. natural selection has tended over the long run to reduce the number and increase the size of certain species of financial institutions, but it has also allowed new species to form and to proliferate, often in very large numbers. There has been considerable “gene flow” between populations as, for example, American banks have exported their modes of operation to other financial centres, though the dominant trend is for genetic mutation rather than homogenization. The evolutionary process has been subject to recurrent exogenous disruptions in the form of geopolitical shocks, financial crises and


regulatory interventions (or lapses). These shocks have led to significant changes to the financial population as whole, and even the outright extinction of entire species.

The evolutionary process is indeed a complex one, not least because of the ebbs and flows of liquidity and global integration, the quite frequent but unpredictable incidence of financial crises and the erratic interventions of legislators. At first sight, there seem to be few rules that can be relied upon for very long – few “north stars” that can be used by the various stakeholders to steer by.

This complexity makes the role of regulators and policy-makers exceedingly difficult. regulators and policy-makers have the power to change the rules of the financial system at a stroke of a pen. This is perhaps the biggest difference between financial evolution and natural evolution, which is widely understood by scientists to operate without a divine guiding hand.

66

4 tHe rOLe OF reGuLAtIOn: InteLLIGent DeSIGn?

Whereas evolution in biology takes place in the natural environment, where change is essentially random in character (hence Dawkins’s image of the blind watchmaker), evolution in financial services occurs within a regulatory framework where – to borrow a phrase from anti-Darwinian creationists – “intelligent design” plays a part. Darwin’s species of finches adapted by random trial and error to the islands on which they lived. In the same way, financial services firms evolve according to the peculiarities of their own environments. But what makes these environments distinctive is not just a matter of economic performance or culture. It also has to do with the role of regulation.

Sudden changes to the regulatory environment are rather different from sudden changes in the macroeconomic environment, which resemble environmental changes in the natural world. The difference is that there is an element of endogeneity in regulatory changes, since those responsible are often “poachers turned gamekeepers”, with a good insight into the way that the private sector works. However, the net effect is the same as climate change in biological evolution. new rules and regulations can make previously “good” traits suddenly disadvantageous.

TheSTAbiliSiNGeffeCTofreGUlATioN

In many ways, the existence of a large number of banks in the early twentieth century was an anomaly created by peculiarities of uS regulation. The 1864 national Bank Act significantly reduced the barriers to setting up a privately owned bank. Capital requirements for banking organisations were low for much of uS history. At the same time, there were obstacles to setting up banks across state lines. The combined effect of these rules was a surge in the number of banks during the late nineteenth and early twentieth centuries. Large numbers of under-capitalised banks were a recipe for financial instability. Bank runs were a regular occurrence and caused the demise of many financial institutions – 4,000 in a single year during the Depression. The introduction of deposit insurance in 1933 did much to reduce the vulnerability of banks to runs. However, the banking sector remained highly fragmented until after 1976, when Maine became the first state to legalise interstate banking.

The rise and fall of Savings and Loans was also due in large measure to changes in the regulatory environment. Designed to take deposits and supply long-term mortgages to local clients, S&Ls came under acute pressure during the inflationary 1970s. Partial deregulation in the 1980s encouraged some S&L managers to adopt reckless and sometimes fraudulent practices. A comparable episode in europe was the Secondary Banking Crisis in the uK between 1973 and 1975, which affected banks that had


been lending money for the purchase of consumer durables. In this case, a “lifeboat” operation prevented thirty of these firms from collapsing, and lent assistance to another thirty that were in difficulty.

Similar interventions by the authorities can be seen to have affected the number of banks in developing economies. In newly independent India, for example, the authorities encouraged mergers and acquisitions. As a result, the number of reporting banks declined from 517 in 1952 to a low point of 90 in 1967. A chronic shortage of rural credit then forced a partial u-turn as the government encouraged the growth of cooperatives and rural branches, increasing the number of bank offices from 8,262 to 42,016. These examples illustrate the extent to which regulators can influence the evolutionary process of financial services, changing the environment in which evolution takes place and the rules under which it operates.

28.bANKiNGfAilUreSANDDepoSiTiNSUrANCeiNTheUS

1865

1869

1867

Number of bank failures Deposit insurance limit

1873

1881

1885

1889

1893

1897

1901

1905

1909

1913

1917

1921

1925

1933

1929

1937

1945

1949

1941

500

1,500

2,500

3,500

4,500

0

2,000

3,000

4,000

5,000

1,000

1953

1957

1961

1965

1969

1977

1973

1985

1989

1981

1993

1997

2001

2005

20,000

60,000

100,000

140,000

180,000

0

80,000

120,000

160,000

200,000

40,000

Bank failuresDeposit insurance

per account ($)

Source: fDiC

The primary focus of most regulators is to maintain stability within the financial services sector, thereby protecting the consumers which banks serve and the economy which the industry supports. Companies in non-financial industries (computing, for example, or automobile manufacturing) are neither so fundamental to the economy nor so critical to the livelihood of the consumer. The collapse of a major financial institution, in which retail customers lose current and savings deposits, is an event which any regulator (and politician) wishes to avoid at all costs – a fact of which British authorities were painfully reminded in September 2007. Bail-outs of failing institutions by regulators through direct capital injections, brokered buy-outs, or

68

outright nationalisations have been a regular feature of policy making since the 1930s and still occur today. In return for their implicit or explicit guarantees to banks, legislators demand a relatively high level of regulatory supervision.

One consequence of this special status is that deposit-taking institutions rarely outperform the sector average. Compared with other industries, performance differences among firms tend to be small within any given regulatory jurisdiction. Banks, in short, do not behave like software companies.

The critical question that has raised its head once again in recent months is whether implicit guarantees to bail out banks create a problem of “moral hazard”, encouraging excessive risk-taking on the assumption that the state will intervene to avert illiquidity and even insolvency if an institution is considered too big – meaning too politically sensitive or too likely to bring a lot of other firms down with it – to fail.

From an evolutionary perspective, however, the problem looks slightly different. It is, in fact, undesirable to have any institutions in the category of “too big to fail”, because without occasional bouts of “creative destruction,” the evolutionary process will be thwarted. The experience of Japan in the 1990s stands as a warning to legislators and regulators that an entire banking sector can become a kind of economic dead hand if institutions are propped up despite under-performance (see box 5).

poliCyCoNVerGeNCeANDreGUlAToryiNDepeNDeNCe

Over the long run, national systems of banking regulation have changed and gradually converged. The central bank is a relatively modern invention, appearing in developed countries at very different times (see figure 29). The first true central bank (in the sense that it acquired de jure a monopoly on note issue and de facto the role of lender of last resort) was the Bank of england, founded in 1694, but not recognisably performing its modern role until after 1873, the year of Walter Bagehot’s definitive Lombard Street. The Banque de France (1800) was a napoleonic foundation; the German reichsbank (1875) a Bismarckian one; the Bank of Japan (1882) a product of the Meiji restoration. The uS had no central bank until the creation of the Federal reserve System in 1913.

Before the First World War, monetary authorities were constrained more by the largely unwritten rules of the game that governed the gold standard and by widely divergent national statutes. The gold standard rules collapsed in the era of the World Wars, and most central banks became little more than appendages of national treasuries and finance ministries, regaining their independence only after the trauma of the 1970s inflation.


2�.TheeVolUTioNofCeNTrAlbANKiNGiNSeleCTeDDeVelopeDeCoNomieSSiNCe1875

1875 1900 1925 1950 1975 2000 2007

Japan

US

UK

France

Germany

Italy

Spain

Switzerland

1874: Banco d’Espana grantednote issuance monopoly

1907: Swiss National Bankestablished

1956:Banco d’Espana nationalised

1893: Bank of Italy formed and given note issue monopoly in 1926

1936: Bank of Italy becomes true central bank

1876: Reichsbank

1882: BOJ established. Becomes LLR in the 1920s (after WW1)

1946: Bundesbank

1913: Federal reserve established

No central bank Quaso-central bank Full central bank

Within the last twenty years, however, there has been renewed convergence at the level of policy setting and decision making. exchange controls and other restrictions on financial services were dismantled in most developed economies in the 1970s and 1980s. Committees of experts are more frequently used to set key short-term rates, inflation targeting is more common as a goal of central banking, and central banks are increasingly independent from government. From 1990 to 1998 more than 50 central banks adopted an inflation targeting policy, compared with just 4 from 1960 to 1989. Money supply targets and exchange rate targets were adopted by, respectively, 23 and 26 central banks between 1990 and 1998, compared with 11 and 24 between 1960 and 1989 (see figure 30). Independence, measured by a set of criteria and scored from one to ten, has increased across central banking organisations in the developed world, though developing markets still lag behind (see figure 31).

yet considerable differences of opinion remain as to the correct basis for the formulation and implementation of monetary policy. The distinctly eclectic approach favoured by the Federal reserve under Alan Greenspan appears to be continuing under his successor, and contrasts in rhetoric and in practice with the modus operandi of the Bank of england (which has pursued an explicit inflation target since 1997) and the european Central Bank (which under Jean-Claude trichet appears to retain at least a passing interest in monetary aggregates). The Fed takes an asymmetric view

70

of asset markets, seeming to worry more about wealth effects on the way down than on the way up, and thereby giving rise to the notion of the “Greenspan put” on the uS stock market. In August 2007, the Bank of england was reluctant to inject liquidity into the markets on the ground that it would be bailing out reckless players. The european Central Bank, by contrast, injected significantly more liquidity more readily than might have been predicted on the basis of previous pronouncements.

Convergence, in short, is very far from complete. Central bank independence remains a fragile construct, with politicians in Britain and France openly criticising their respective monetary authorities during the recent credit market crisis.

30.ADopTioNofexChANGerATe,moNey,ANDiNflATioNTArGeTiNGbyCeNTrAlbANKS

20

40

60

80

100

120

140

160

01960s 1982 1986 1990 1994 1998

Money target Inflation targetExchange rate target

Central banks using target

Source: Sterne(2001)


31.CeNTrAlbANKpoliTiCAlANDeCoNomiCiNDepeNDeNCe

Politicalindependence

Economicindependence

7

6

5

4

3

2

1

0Political

independence

Notavailable

Economicindependence

Notavailable

Developedmarkets

Developingmarkets

1991 2003

Index ofIndependance

Source: Arnone,laurens,andSegalotto(2006)

For most of the past century, financial markets and financial services companies were very loosely regulated by present standards. Many central banks in the late nineteenth century were privately owned, and as such remained somewhat insulated from overt political influence. Indeed, it took some time for their directors to acknowledge the priority of their shareholders’ interests. Prior to the Great Depression, there was very little regulation, least of all in the uS where Hayekian free banking prevailed for most of the nineteenth century.

That changed in 1934 with the creation of the Securities and exchange Commission, an independent, non-partisan agency with quasi-judicial powers. Between 1933 and 1940, six major laws were passed relating to the securities industry, which the SeC was empowered to enforce. no major change occurred to this legal framework until the passage of the Sarbanes-Oxley Act in 2002 which, like most such legislation, was enacted in response to a crisis (the wave of accounting scandals exemplified by the collapse of enron).

The Financial Services Authority in London is of much more recent origin. Originally established as the Securities and Investments Board of 1985, the FSA took on its current form in 1997 at the same time as the Bank of england partially regained its independence in the determination of monetary policy.

72

box4–TheJApANeSebANKiNGCriSiS

Sometimes it can be difficult to remember that large, well-capitalised and apparently stable banking systems can completely collapse. But it has happened several times in recent memory. Sweden saw its entire financial system hospitalised from 1991 to 1994, and Japan’s famously collapsed in 1997. Though the reasons for the collapse seem fairly obvious now, nobody saw it coming.

In the post-war period between 1945 and 1973, Japanese banks enjoyed a position of pre-eminence. Savings were channelled into these banks and restrictions on other financing options made them the prime financiers. The 1970s, however, brought about regulatory changes that eroded their power base and left the Japanese banking system in turmoil.

The reform process saw the deregulation of financial markets and easing of restrictions on the issuance of equities and bonds. Larger Japanese corporations once reliant on bank financing shifted to the bond markets, as did other investors looking for more attractive and easier options for financing and investment. Sticking to their traditional lines of business, Japanese banks turned their lending priorities to individuals and the commercial real estate industry, which are generally risky in nature.

In the mid 1980s, high economic growth and near zero inflation boosted asset prices to unprecedented levels. This, coupled with aggressive lending in a bid to capture market share, left banks with large non-performing collateral-based loans when the bubble finally burst in 1989. Banks’ ratings declined, raising their funding costs above those of their clients. Clients began issuing debt rather than borrowing, further impacting the quality of the banks’ balance sheets. Many banks complied with Basel I at the time of introduction, using shares on the balance sheet to constitute much of the capital.

The early nineties saw a tightening of lending requirements, but many problems were simply disguised: non-performing loans remained unnoticed, as they were simply restructured and reclassified; problem loans were moved to related companies whose financial status was not consolidated; convertible bonds were issued to improve the capital position of banks.

Banks began to enter insolvency in 1997 as depositors aggressively removed deposits from weakened institutions, despite government guarantees. The government also injected ¥1.8 tn directly into banks, putting aside a further ¥60 tn to support failing banks. Banks were closed or suspended through much of 1997 and 1998.


The Financial Supervisory Agency was set up and conducted a series of on-site evaluations of banks, concluding that their credit quality was massively underestimated. values of some banks turned negative when they were asked to increase their provisions on certain portions of the book. In September 2003, Japanese banks still had an estimated ¥21.5 tn of non-performing loans for which they had not made any provision.

WorlD’STopTeNbANKSbyTieroNeCApiTAliN1�87,1��7AND2007

1987 1997 2007

1barclaysbank hSbCholding

bankofAmericaCorp

2 NationalWestminsterbank

ChasemanhattanCorp

Citigroup

3Citicorp AgricoleGroup hSbCholdings

4CreditAgricole Citicorp

CreditAgricoleGroup

5 export-importbankofJapan

bankofTokyo-mitsubishi

JpmorganChase&Co.

6Sumitomobank Deutschebank

mitsubishiUfJfinancialGroup

7 UnionbankofSwitzerland

bankAmericaCorp

iCbC

8Deutschebank

AbNAmrobank

royalbankofScotland

9SwissbankCorporation

Sumitomobank bankofChina

10fujibank

Dai-ichiKangyobank

Santander

Source: Thebanker

Following the crisis, Japanese banks all but disappeared from the list of the largest banks in the world, to be replaced by Chinese banks. Though banking crises in developed markets are by no means common, it would be foolish to believe that the list of the top ten banks in 2017 will resemble that of 2007.

7474

At present, most financial regulation is national in character. Here, too, we see an evolutionary tendency, as competition between different financial centres (notably new york and London) has led to pressure for harmonisation though the lustre of Britain’s “principles-based” approach has been somewhat tarnished by the northern rock debacle. efforts to create an international regulatory framework for financial services continue, with mixed results. The World Bank and the International Monetary Fund offer some kind of international structure for sovereign borrowing by poor or crisis-stricken governments, but efforts to establish a regime to govern global capital flows (the way the World trade Organization governs trade) have so far proved fruitless.

exchange rates since the collapse of the Bretton Woods system in the early 1970s have been determined by central banks on a largely ad hoc basis, with only occasional collective “accords.” The most important international regulatory advance has related to bank capital requirements and has been carried out under the auspices of the Bank for International Settlements. It remains to be seen what the effects will be of the transition from Basel I (agreed in 1988) to the more sophisticated rules of Basel II, which are due to be adopted by at least 95 national regulators by 2015.

oVerVieW

The global financial services industry operates under a multitude of legal and regulatory frameworks, many of which overlap and are inconsistent with each other. The principles of Darwinian natural selection can, in theory, apply to regulatory frameworks as well as to financial services providers. However, in practice, no dominant “intelligent design” can hope to emerge in a context where there are no universal metrics of success and where political interference is a regular occurrence. Given all this, it is not surprising that the impact of regulation has been, at best, mixed.

regulators seem to face a number of conflicting objectives. Protecting the consumer adds cost indiscriminately to all providers. encouraging new entrants creates new risks. Increasing transparency can punish innovators. More level playing fields actually favour the least efficient incumbents. Investor protection can lead to prolonging the life of failed business models. What is an enlightened regulator to do? What can a well-managed firm reasonably expect the regulators to do?

In the next chapter, we seek to draw some conclusions from our evolutionary account for the sector and to offer some medium-term guidance for financial service providers and regulators.


5 evOLutIOnAry LeSSOnS In FInAnCIAL ServICeS

Going beyond superficial Darwinian analogies, our historical approach offers an adapted version of evolution as a framework for understanding the development of financial services. In this chapter, we describe the main elements of this framework and then apply it to make sense of historical facts and apparent paradoxes. We draw practical lessons about financial services of the future and apply them to a few concrete problems that the industry faces today.

ANeVolUTioNAryfrAmeWorK

There are three fundamental reasons why we see evolution as a better framework for understanding financial services.

First, neither evolution nor financial services has a single, long-term objective function. evolution does not have a purpose and does not, inherently, prefer certain species or attributes to others. It does not aim (as used to be thought by anthropocentric victorians) to produce homo sapiens as the finished product of life on earth.

The provision of financial services does not have a single end-goal either. In the late 19th century, for example, the facilitation of trade and gold convertibility were paramount objectives, closely followed by the mobilization of small savings into the bond market via savings banks. Altogether different priorities dictated the evolution of finance in the 1940s and 1950s, when most financial institutions found themselves subordinated to national plans for wartime destruction or peacetime reconstruction.

Objectives differ across geographies and end-user segments, and are often conflicting even in the same segment. Some microfinance lenders, for example, are in business to make a profit; others are in business to help the poor.

In short, it is impractical to define the desired end-state of financial services through a finite number of objective metrics. Far from converging towards a single performance measure, evolution ensures that there will continue to be speciation among service providers, just as there will be increased diversity among end-users. Money can change hands in a multiplicity of ways for a multiplicity of purposes. In both financial and biological evolution, the sole common objective is to avoid disappearance.

Second, no formula works forever. Species that prosper and seem indestructible for long periods can still fall victim to competing species or environmental changes. This is also fundamental to financial services: There is no perfect provider type (or regulatory framework) that will remain successful and dominant into the future. Structures that were highly successful in the past – for example, the German “three pillar” system

76

of banking – eventually come under pressure and decline in their effectiveness. Barriers to entry may, indeed, stay very high for long periods as in the case of large loss insurance during the 19th century, or the current scale game in custody services. However, seemingly failsafe formulae stop working as alternatives surface, technology advances, and the economic environment changes. Indeed, an important similarity between financial services and an evolutionary system is that the more successful a form becomes, the less robust it gets if the result of its success is that variance declines. Sometimes it really is the case that “the bigger they come, the harder they fall”.

Third, mutation is built into the system. In financial services, perturbations arise from the human element, inter-connectivity, and exposure to external forces. Without ongoing change, the tendency would be to drag financial services down to the lowest common denominator; that was the root of the problem in 1980s Japan. Perhaps there really would be consolidation and convergence into one vast global monopolist, as the socialist theorists of a century ago imagined.

In practice, over the long term we see greater diversity and higher rates of innovation in financial services. We estimate that over half of today’s high-growth, high-profit segments of the industry exist as a result of small changes – either proactive experiments or reactions to external stimuli – that then led to the creation of new markets or new ways of delivering traditional services. As with evolution, the majority of mutations are unsuccessful, but without them the end result would be stasis rather than the vibrancy that we observe.


These fundamental forces set up a dynamic environment that continues to generate new forms both randomly and (unlike in natural evolution) through conscious adaptation to external changes.

Time (decades)

No formula works forever

No single, stable objective

Rapidly changing environment

Pool of forms

No convergence; Continuedevolution

Adaptive Extinct

Multiple, overlapping shifting objectives

Spontaneous new

Mutation

A further important point is that the stakeholders in financial services are also part of the evolutionary process of change. Over a long period of time, the needs and preferences of end-users, employees and investors change as greatly as those of financial service providers and regulators. The table below gives a few examples of broad changes that have happened over long periods and that have set off new internal dynamics within the framework.

78

Internal change Pressure points Impact on evolutionary process

Small-andmedium-sizedenterprisefocusshiftingfromworkingcapitalfinancingtostrategicadvisory

bankshadinvestedinexpensivedistributionbuttheircoreproduct–credit–haslostrelevance

encouragesnewformsofdirectlendingtoSmesegment;placestraditionalSmemodelsontheendangeredlist

Super-wealthyagendashiftingfromwealthcreation/protectiontowardsaddressingglobalissues

privatebanksandwealthmangersolutionswoefullyinadequateforthetrulyrich

encouragescaptivewealthmanagersasanewevolutionaryform;strengthenschancesofnot-for-profitorganisationstoincreasemarketrelevance

massretailagendanotshiftingfromconsumerismtoold-ageprovision

Governmentsfacingimplicitlong-datedexpendituredemands

Shiftsevolutionarymomentumfrominvestmentsalestoindividualstowardsfinancingstateinstitutions

younggenerationsexpectingjoined-uptechnologysolutionstoallfinancialneeds

financialservicesfirmshavebecometechnologicallyirrelevant,despitespending20-50%oftheircostbaseontechnologyandoperationalprocesses

opensupmajorpartsoftraditionalfinancialservicestotech-savvyproviderforms;cancreatehiddenregulatoryproblems

Serviceprovideragenda(toconsumerfinancialserviceproviders)shiftingfrommicro-productprovisiontoplatformoutsourcing

Costof“bespoke”moduleswillspiral,whilecheapwholeplatformswilllosedistinction

forcessharperdistinctionbetweencustomiseddistributionfirmsvs.scalemanufacturing;opensupvastpartsoftheindustryvaluetoalternativeprovidersandalternativeinvestors

Top-endemployeepreferenceshiftingfromtenuredsalariestoprofit/equityownership

Difficultforintellectualcapitalbusinessesinfinancialservicestodeliverconsistentlytoshareholders

explicitorhidden“public-to-private”formsemerginginfinancialservices–willfavouradvisoryboutiquesandfirmsthattoleratehighpay-outratiostoproducers

investorsattachinghigherpremiumto“owner-like”managers

Traditionalassetmanagers(especially“active”ones)losingmarketsharerapidly

Catalystforawholenewwaveofalpha-drivenassetmanagers;bynaturethesearemoretransientandmorevolatile

regulatorsincreasinglyregardingthestatusquoasagoodinitself

pocketsofsuppressedevolutionco-existingwithmarket-drivenformswillimposesignificanthiddencostson“protective”domesticmacroeconomies

Netlosstothesystemassuperiorformsareexcludedfromlargepartsoftheenvironment,andasultimatelydoomedformsarekeptalivein“sanctuaries”

Sovereignwealthfundsre-emergingandbecomingmoreactivelyinvolvedinfinancialservices

Anewsourceoflargelyinexpertcapitalwillfurtherreducecostofcapitalonanarbitrarybasis

Createsrandomisedspeciationopportunitiesandelongatescertainextinctiontrajectories


to illustrate the power of this framework, it is instructive to compare its features with two alternatives that have been implicit in the observations and actions of many industry participants.

Evolutionary Deterministic Stochastic

Overview Adynamicequilibriumwhereallaspectsoftheindustryevolveduetoacomplexsetofdrivers,withnoconvergencepossible

Anadaptivesystemwhereanumberoffundamentalrulesprevail,sothattheresultsofanystimuluscanbepredictedwithenoughinformation,and–givenenoughtime–astaticequilibriumcanbereached

Arandomisedsystemwhereresponsestoeventsaredrawnfromexplicitorimplicitstatisticalfunctionsandwherenoequilibriumispossible

Fundamental drivers Currentpoolofforms

mutation

lackofsingleobjective

Nostableformulae

Uncertainoutcomeofenvironmentalimpact

Underlyingsetofruleslinkinginputstooutputs

externalinputs

Underlyingsetofstochasticfunctionslinkingstimulitoresponses

Applicability mostusefulwhentherearebothlong-termtrendsandshort-termeffectsinplay

mostusefulwhenstablerelationshipsareobservedbetweencausesandeffects

powerfulwhenrangeofoutcomesismoreimportantthanspecificoutcomescenarios

Demand structure Dynamicanddrivenbybothexternalandinternaleconomicandotherneeds

formulaicandsubjecttostagesofdevelopment

randomisedwithdirectionalprogressandsignificantnon-predictablevariationaroundthemean

Supply structure Dynamicandsubjecttoadaptationandspontaneouscreation/extinction

formulaicandresultingfromshiftingpricesoffactorsofproduction

randomsothatunexpectedsuccessesandfailuresarethenorm

Stakeholder hierarchy Complex,interdependentandshiftingovertime

ownersoffactorsofproduction(human,financialandinfrastructuralcapital)asthekeydeterminants

irrelevantunlesscertaingroupscanre-shapeunderlyingstochasticprocesses

Endgame Continueddynamicequilibriumthatseesadaptationandcreativedestructiononasyncopatedbasis

inexorabledrifttowardsastableequilibriumwhereacomplexobjectivefunctionismaximised

pattern-lessdriftthroughfuturemacroeconomicandenvironmentalscenarios

Relevance to today’s financial services world

mostclearlyobservedinleastregulatedpartsoftheindustry,e.g.hedgefunds

observedinhighlyplannedeconomiesand/orhighlyregulateddomesticfinancesectors

observedinrapidlyexpandingnewmarketsectorswherenoclearwinnerscanbediscernedyet

So what if it is right? Donotwasteresourcesoncontrollingevolution;createtransparencyandlevelplayingfieldstotheextentpossible

Continuouslylookforthe“grandrulebook”thatdefinesasuccessfulfinanceindustry

Createinsurancemechanismsagainsttheextremedownsidescenariosandplanresponsesinaninherentlyrandomworld

80

In the following sections, we demonstrate the usefulness of the evolutionary framework by applying it to past events, current challenges and the future of the industry.

DrAWiNGleSSoNSforThefUTUre

Let us now review the principal environmental and evolutionary tendencies, to see how far we have left the consensus view behind.

Consensus view Shortfall versus evolutionary perspective

Macroeconomic stability Unsupported macroeconomicinstabilitywasahallmarkofthemid-twentiethcentury;today’sstabilityresemblesthatpriortothefirstWorldWar

Liquidity and global integration

Unsupported liquidity,thoughhightoday,hasbeenhigherbeforeandhasdisappearedsuddenlyinpastcrises

Demographic change Unsupported Societyisbeginningtosupportanincreasingnumberofdependents,butthedependencyratioisnotclosetoitshistorichigh

Global imbalances Unsupported Theworldhasbeenverygloballyintegratedbefore–asintegratedasitistoday.Theperiodfrom1�14to1�7�revealedtheeasewithwhichintegrationcouldbereversedandthedifficultyofrestoringit

Technology and productivity

Unsupported pasttechnologicalinnovationshavenotalwaystranslatedintomajorgainsinfinancialsectorproductivity

Risk management Supported -

Ownership Unsupported The‘new’ownershipstructuresseentodayarenotsignificantlydifferentfromthoseseenthroughouthistory

Regulation and supervision

Unsupported Thefinancialsystemisnotnecessarilymorestabletodaythanduringthelaissez-faireeraofthelatenineteenthandearlytwentiethcentury

mACroeCoNomiCSTAbiliTy

relative macroeconomic stability has been a hallmark of the last decade, no doubt, but in the context of history it is relatively unspectacular. Most measures show the world economy to have been equally dynamic at the end of the nineteenth century, though growth in the first age of globalisation was admittedly somewhat lower and more volatile. There is no guarantee that volatility will not return with a bang in the decade ahead.


liqUiDiTyANDGlobAliNTeGrATioN

Though undoubtedly higher today than it was 20 or 30 years ago, liquidity is not exceptionally high in a longer-term perspective, at least by some measures. The increasing liquidity of assets other than cash and deposits means that using the money supply as a measure of overall liquidity can give an incomplete picture. The stock and bond markets have outgrown the money supply, and are larger as a proportion of GDP today than they were a hundred years ago. Moreover, the evolution of capital markets has meant that more and more assets have become liquid in the sense of being quickly and easily tradable at a market price. even real estate is now traded through reIts on stock exchanges, albeit in negligible volumes compared with the universe of real estate and the trade in other liquid assets. This is the sense in which the financial world today is awash with liquidity.

nevertheless, recent events have exposed the potential for acute illiquidity in new markets that have arisen outside the traditional framework of the stock and bond markets. CDOs, especially those secured on sub-prime mortgages, have proved to be potentially highly illiquid, even the tranches classified as AAA by the rating agencies. In August 2007, a number of banks and other institutions that held CDOs found themselves in such difficulties that central banks were forced to act not only as providers of liquidity but also as lenders of last resort through the discount window. Peer institutions were unwilling to lend, given that the value of the CDO tranches, SIvs, and conduits they held had become impossible to measure, the secondary market having all but collapsed. This reduced the ability of banks to measure their own potential losses and each other’s potential riskiness. The lesson is clear: Liquidity can disappear very suddenly from a segment of the financial system, even at a time when it seems to be abundant in the system as a whole.

The current turbulence in the credit markets points to just such a downturn in the liquidity cycle. Here we use another definition of liquidity: the ease with which an asset can be bought or sold on the stock and bond markets. As figure 32 shows, bid-ask spreads have fallen considerably since the early 1990s (some of which can be attributed to technological improvements in trading systems), but they are now edging upwards again. Though this metric measures just one aspect of liquidity, it may be suggestive of a broader change.

82

32.AVerAGebiD-ASKSpreADSoNWorlDSToCKexChANGeS

0.50%

1.00%

1.50%

2.00%

2.50%

0.00%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

Contraction Contraction Contraction?

Source: Datastream,oliverWymananalysis

Our own measure of liquidity also contracted during the volatile markets of 1997 and 2000, slowly expanding thereafter (figure 33). The liquidity metrics driving the downturn vary on each occasion, however. During the summer of 2007, bid-ask spreads and short-term money market rates were strong indicators of the downturn, while in 2000 it was the money supply that fell sharply.

33.liqUiDiTyDUriNGTimeSofCriSiS

100

110

120

Month1

Month2

Month3

Month4

Month5

Month6

Month7

Month8

Month9

Month10

1994 2000 2007

70

80

90

40

50

60

30

April 2000, May 1994,August 2007

Oliver WymanRebased to 100 at liquid peak

Source: Datastream,Worldfederationofexchanges,oliverWymananalysis


each peak signifies a drying up of liquidity. Bid-ask spreads widen and interest rates rise as money becomes more scarce and expensive. The capacity of central banks as lenders of last resort is critical during these stages in the cycle. By injecting liquidity into the market, central banks enable financial services organisations to cover positions without incurring large losses. There was no real reason prior to the summer of 2007 to believe that this cycle had been abolished.21

Central banks tend to act as lenders of last resort to their national (or, in the case of the eCB, regional) markets. yet globalisation means – and certainly meant last summer – that a liquidity crisis in London can have an impact on other financial markets. As we have seen, although it is quite integrated today, the world economy is not exceptionally integrated in the context of the last hundred years. Further integration in the coming decade, however, would take us into uncharted waters. Clearly, global financial integration has the great benefit of allowing the savings of Asian and Middle eastern economies to be channelled into the debt markets of countries with a higher propensity to consume. On the other hand, global integration has attendant risks. even in times of relatively low global integration, major financial crises can quickly spread across borders. In today’s world, the potential for contagion is arguably higher than ever.

Stock markets have shown remarkable levels of correlation with one another in times of prosperity and during extreme crises (see figure 34). The three peaks in correlation during the twentieth century occurred during and prior to the First World War (Globalisation 1.0), during the Great Depression and again today (Globalisation 2.0).It was notable that all stock markets were negatively affected by the August credit crunch, and all responded in unison to the accommodative moves of the Fed and the eCB.

An integrated global economy, in short, may be more susceptible to contagion than a non-integrated one. to be sure, the more integrated economies are, the less protracted crises tend to be. Capital is able to move to affected areas much faster and in greater quantities, and open economies can return to growth much faster than closed ones, as trade helps fuel demand when domestic consumption is weak. nevertheless, the susceptibility of globalisation periodic and highly correlated crises remains a critical feature of the macroeconomic environment.

21 SirAndrewlarge,“Whyweshouldworryaboutliquidity”,financialTimes,11November2004

84

34.GlobAlSToCKmArKeTCorrelATioNS

WorldWar I

WorldWar II

1.0

Correlation of world stock markets

0.8

0.6

0.4

0.2

0.0

-0.21870 1878 1886 1894 1902 1910 1918 1926 1934 1942 1950 1958 1966 1974 1982 1990 1998 2006

Ten year correlation Twenty year correlation

Source: GlobalfinancialData.CorrelationsareforUS,UK,franceandGermanyplusJapanfrom1�16

DemoGrAphiCChANGe

High dependency ratios are nothing new, but there is a difference between a youthful society and an aged society. Current demographic trends clearly favour the economies of younger developing countries, whose share of the world’s working age population is expected to increase from ~80% today to ~90% by 2050 (see figure 35). The major impact of demographic change will be a shift in the way that society’s dependents are supported, rather than a crisis resulting in the cost of dependents becoming overwhelming.


35.DeVelopeDANDDeVelopiNGeCoNomyShAreofWorlD’SWorKiNGAGepopUlATioN

10%

30%

50%

70%

90%

0%

Developed country share Developing country share

1950

1960

1970

1980

1990

2000

2010

2020

2030

2040

2050

40%

60%

80%

100%

20%

Forecast

Source: UN,oliverWymananalysis

At the country level, there may well be individual pension fund crises in developed economies. The legacy of China’s one-child policy will clearly create a major difficulty for that country in the foreseeable future, as the dependency rate soars. today, less than 8% of China’s population is 65 or older. By 2050, that proportion could have risen as high as 24%.

GlobAlimbAlANCeS

It is widely taken for granted that the growth of the economies of China and India is unstoppable, and that the financial services sector in Asia will grow proportionately to or even faster than the economy as a whole. There are, however, several potential obstacles to the unfettered growth that the financial services sector is now experiencing in China. As profit margins rise through innovation and scale benefits, there is the potential for a regulatory backlash aimed at checking these trends. Capping of interest rates, taxation, or other barriers would all slow the growth of the industry.

If China were somehow to avoid a serious financial crisis in the next decade, it would become the only country in history to have industrialised without one. China has come a long way in terms of recapitalising its banking system. It has made (and is still making) a series of welcome and crucial reforms. risk measurement capabilities have considerably improved. But the fundamental approaches to capital allocation and risk management remain unreconstructed in many cases. With balance sheets expanding rapidly as the economy booms and large numbers of retail and commercial customers

86

begin using financial services, difficulties seem certain to arise. A financial crisis in China could be triggered by a number of different events, including a sudden, major revaluation of the yuan or a crash of the Shanghai stock market (which at the time of writing, is exhibiting distinctly bubble-like characteristics).

It seems reasonable, in short, to assume that the near future will not necessarily be like the recent past. The long-term perspective makes us aware of a whole range of ways in which the global economy could suffer setbacks in the decade ahead.

Having reviewed the prospects for the global environment, let us now turn again to the evolutionary processes at work within the financial services sector.

TeChNoloGyANDproDUCTiViTy

There are two schools of thought about the impact of technology on financial services: either they treat technology as an external given that comes from outside financial services and impacts everything including that industry, or they see innovation as an amorphous mass of experiments that are partly endogenous. Both of these perspectives, nevertheless, encourage us to expect continued rapid innovation. nevertheless, a longer-run view suggests that technological innovation is not guaranteed to generate productivity gains on the scale we have witnessed in recent decades. As we have seen, there was very little technological innovation in financial services until the 1960s and 1970s, despite the fact that the first half of the twentieth century witnessed exponential technological advances in a wide range of other economic sectors. The possibility exists that the computer revolution has done most of what it can do to improve productivity in financial services.

This scepticism may be consistent with the observation that many new financial service providers are relatively small entities (like hedge funds and private equity partnerships). Though all make some use (and a few make a great deal of use) of computerised trading systems, to a large extent these firms deal with their investors and targets of investment opportunity on a personal, face-to-face basis. The relationships involved are unlikely ever to be automated in the way that the relationships between a retail bank and its account holders have been in recent years.


riSKmANAGemeNT

risk transfer through more developed cash, capital, and derivatives markets has enabled the management of credit risk to be much more efficient than in the past. to be sure, the transition away from traditional balance sheet banking is by no means complete. Deposits remain the single most important source of bank funding worldwide, and in some markets, notably the uS, generate more banking profit than any other product. nevertheless, investors’ appetite has grown dramatically for secondary loans and other financial assets originating at banks in the form of MBS and ABS, products that were effectively non-existent as recently as 1980. Though direct sales of loans (including the entire books of banks in financial difficulty) are nothing new, it is only recently that an active secondary market has developed for securitised products (though secondary trading in syndicated loans was common during the 1980s). As commoditised and homogenous securities, MBS are much more actively traded and considerably more liquid. A liquid market for bank-originated assets enables much faster, more effective, and cheaper risk management.

The use of derivatives has also increased significantly. total derivatives outstanding were negligible in the mid 1980s compared with today, while the market for CDS was still tiny as recently as 2000 (see figures 36 and 37). Derivatives growth over the last decade has been driven more by credit products than by market risk products, which also began to grow rapidly in the 1990s. CDS purchases have grown especially quickly (though they make up a small proportion of total derivatives sales), largely due to rising demand from banks stemming from the introduction of the Basel II regulations. total OtC derivatives outstanding amount to ~$400 tn, of which CDS account for ~$30 tn. It is in this area that risk management has evolved the most over the last decade, not only by allowing banks to hedge and manage credit risk (historically the most frequent cause of bank failures), but also by allowing hedge funds and other investors actively to trade credit risk exposure in a way never possible in the past.

Though syndicated loan trading increased hugely during the 1980s and 1990s, the current ease with which credit risk can be managed would have been hard to imagine even then, let alone a hundred years ago. Here we are very clearly in new territory without historical precedent to guide us.

88

36.oTCDeriVATiVeSoUTSTANDiNG

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

50,000

1987

Foreign exchange contracts Equity-linked contractsInternet rate contract

0

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

National amount outstanding ($BN)

Commodity contracts CDS Other

Source: iSDA,biS

37.oTCCDSoUTSTANDiNG

5,000

10,000

15,000

20,000

25,000

30,000

35,000

2001 2002 2003 2004 2005 20060

National amount outstanding ($BN)

Source: iSDA

It is not difficult to visualise a future in which banks have fully separated the management of the asset side of the balance sheet from the origination of assets in the market. As the stalling of credit markets during the summer of 2007 revealed, the movement to full separation of risk origination and balance sheet management in banking is far from complete. Our sense, nevertheless, is that the benefits of these innovations will continue to outweigh the costs that were revealed last August. In evolutionary terms, financial institutions that fail to exploit the new financial


technology and risk management are almost certain to lag behind their more adaptive competitors. In this one respect, we feel that the conventional wisdom is validated by our long-term survey of the financial evolutionary process.

oWNerShip

nothing better illustrates the degree of diversity in the financial services sector than the variety of structures of ownership that currently co-exist.

State-owned banking organisations are certainly less common today than they were fifty years ago. But conglomerate ownership of financial services operations by the likes of Ge, by contrast, appears to be enjoying a resurgence. retailers and manufacturers are also entering the markets for banking and consumer finance in europe, while in Asia the South Korean chaebols and their financial services subsidiaries are becoming ever stronger.

Though ownership of the largest financial services organisations is now almost exclusively through joint-stock structures, more and more smaller organisations are now very commonly privately owned, in the same way that many of the most important financial services companies of the early twentieth century were also privately owned.

If private equity and other active investors demonstrate consistently superior returns in more difficult economic conditions, this may prove to be the beginning of a fundamental change. One scenario is that activist investors might attract an increasing share of collective savings, at the expense of more passive institutional investors. More probable, in our view, is the evolution of a symbiotic relationship between the large institutional investor species such as pension funds and insurance companies and the new species of more agile, aggressive investors. The former will either acquiesce in or, more likely, positively support moves by the latter with respect to specific investment decisions (as we have already seen happen in cases such as the ABn AMrO takeover battle).

Moreover, the move towards more active institutional investment could itself create some second-order effects. First, companies in more open national or regional markets may create even more value and therefore be better equipped to grow beyond these markets, increasing their global market share. Second, in the short term, as a consequence of tighter financial management, companies at the margin may become less able to withstand financial pressure in periods of post-recession recovery, when reflation of balance sheets often strains to the breaking point less well-capitalised companies, at a time in the cycle when bank finance is less available. Third, more volatile employment markets may create potential backlashes from organised labour, which is already viscerally suspicious of private equity.

�0

reGUlATioNANDSUperViSioN

The mainstream view is that by learning from the past and having better policy tools, the financial services sector is more resilient to external shocks. This view seems highly dubious. Major firms continue to get into difficulties in highly developed economies despite all manner of regulation, supervision, and systemic protection – northern rock in the uK, Countrywide in the uS and IKB in Germany are just the latest examples.

The shortcoming of the consensus view is, again, embedded in its fundamental precepts. under a deterministic model, past mistakes should, indeed, help to create better solutions in the future and – over time – the whole system should indeed be made more robust by the repeated application and refinement of such solutions. under a stochastic model, “events” belong in the tails of the probability distributions that govern everything, and until the shapes of these distributions change we should expect the same types of shocks as we have seen in the past and – having lived through the previous ones – should be better prepared for the future ones.

neither of these models generates the right answer here, as the industry keeps experiencing new shocks that surprise the most seasoned participants. under the evolutionary model, which posits that no formula works forever and that there is no single objective function, the expected outcome is different. This model predicts that there will be new and different types of external and internal shocks to come; that past responses to these shocks will not necessarily work; and that large-scale changes will be seen in the industry landscape, try as we may to avoid them.

regulators and supervisors therefore have a privileged position in the system of financial evolution, but they also have limited power. They cannot change the macroeconomic context, nor the fundamental forces driving financial services and other sectors. What they can do is to act as the guardians of transparency, to generate early alerts of specific negative scenarios, and to help accelerate moves back to market normality when manageable shocks occur.

This is a very different regulatory/supervisory agenda from traditional models, which tend to be focused on consumer protection, systemic risk management and financial stability. A clear implication of the evolutionary model is that none of these traditional objectives of regulation can be achieved at all times. Indeed, by setting up such objectives for regulators and supervisors of financial services, policymakers are simply creating a pipeline of future “failures” which – in reality – are failures of expectation rather than of the regulatory framework.

today, regulators seem increasingly to be running the risk of preventing creative destruction from ever happening in regulated finance (i.e. banking). In our view, this is more a serious problem than moral hazard, since it risks the prolonged survival of the

�1THE EvoluTion of financial sErvicEs

unfit. On the other hand, so long as new entities (hedge funds, private equity) can arise and operate outside the pale of regulation, the sector as a whole will remain dynamic. We would therefore be firmly against any significant extension of the regulatory pale, despite the repeated calls from American and european politicians for tighter control of hedge funds and private equity.

�2

prACTiCAlleSSoNSforiNDUSTryleADerS

In reading the above, industry leaders including chairs of supervisory boards, CeOs and heads of strategy, could be forgiven for treating it merely as an interesting historical treatise. As with most new paradigms, the evolutionary theory of finance does not offer conventional lessons to practitioners. The take-home here is not simply grow or die, diversify or perish, stick to your core knitting or unravel – alluring though such simple mottos may seem. In this section we suggest some more profound lessons and apply them to a few of the problems, that many industry participants currently face.

Lesson 1 – Keep it natural

In finance, as in the biological world, natural is best. This plays out in multiple ways for the top leaders of a firm. “natural evolution”, based on building incremental capabilities, markets and businesses, works well and creates sustainable entities in a world that is inherently volatile and instable. This type of evolution can be through organic or non-organic growth, or even through spontaneous creation of a small, innovative fast growth firm. By contrast, “forced evolution” – the type that creates a Frankenstein monster by bolting together unconnected entities with different DnA and metabolisms – invariably fails sooner or later. As a chairman of a bank or insurance company, are you presiding over the creation of an entity that is evolving logically relative to its current form and available habitats?

Another aspect of “keeping it natural” is to make sure your internal rules reflect the rules of the real world. too many financial services providers fall into the trap of managing their key resources (human talent and their time/energy, economic capital, investment funds, customer franchise) according to esoteric internal lenses that drift far off the external world. If a wholesale bank does not differentiate bonuses greatly between superb and average producers, it will lose its best people because the market certainly makes such distinctions. If a payment processor deploys technologies that treat all customers as the same average customer, it leaves the door open for many new entrants. If you allocate capital according to old models that do not reflect economic risks, you will lose volumes or value or both.

Finally, top management needs to be aware of “unnatural habitats” created by either too little regulation, or the wrong type of regulation. These usually manifest themselves as hugely attractive markets that are highly protected (e.g. banking supervisors who discourage foreign entry into a country), very high growth detached from fundamentals (e.g. sub-prime mortgages and consumer finance), or very low risk (e.g. countries where the state always bails out companies for political reasons). Such markets are decoupled from economic reality. relying on them to guide a firm’s evolution usually results in institutional forms that are highly vulnerable to the removal of the market anomaly.


Lesson 2 – Evolution does not wait for industrial plans

With surprising conformity, financial services firms continue to define “strategic visions” and annually updated “five-year plans”. The idea is to carry out appropriate analysis that points to the optimal destination a few years out. Many firms feel incomplete without this. They want to have both easily digestible “soundbites” and mountains of back-up information and research that capture and justify their grand strategic plans. One large bank recently estimated that its annual exercise costs 500 person-years. In an evolutionary world, however, sustained superior execution beats the best-laid strategies every time. your firm is in the middle of a journey and – since the end of the journey is too uncertain to be meaningful – evolving on the go is often the best strategy.

Before describing some actions implied by this lesson, we must point out its most beneficial aspect. It avoids costly, and in some cases catastrophic, mistakes. Over the decades, the elaborate, aspirational strategy has frequently resulted in false destinations: retail banks trying to become global investment banks, wholesale banks becoming commodities traders, insurers becoming alternative asset managers with third-party clients and many firms becoming “supermarkets”. If they had been grounded in the reality of a natural evolutionary path, none of these expensive mistakes would have been made.

to make the most of the journey, learning (copying if necessary) and adaptation are key. Continuous, stepwise innovations beat grand (re-)designs every time. That means finding the parts of your own businesses that provide real competitive advantage and learning from them how to perform better elsewhere. It means rewarding those that consistently deliver relative to market norms, rather than those that have great plans and presentations.

Along the journey, your firm will meet new life forms. They will have a different “DnA”, different business cultures and different business models. Both behavioural adaptation and physical recombination can help you absorb their best features. In the financial world, it is astonishing that the same mistakes are repeated across different businesses, geographies and epochs. The lessons of past real estate crashes don’t seem to have been learnt, for example, while poor distribution management is still prevalent in many european countries.

On the journey, too, opportunities will present themselves – some real and some illusory. the clever firm monetises these as it goes along but within a highly disciplined framework. trade buyers all missed the Long term Credit Bank of Japan, leaving a private equity firm to make a substantial return on it for its investors. More recently, Santander bought two businesses from ABn AMrO, selling one at a profit and hence acquiring an important asset in Brazil at no net cost.

�4

Lesson 3 – Make yourself more attractive

Both biological forms and financial services firms need the right type of resources to adapt sucessfully within their evolving environments. Financial services firms have to attract and retain human talent, capital, customers and technological assets. too many financial services firms have completely undifferentiated messages for these different resources: “People are our most important asset”; “We run according to shareholder value principles”; “your call is important to us”. Is your firm doing the right things to attract all three?

talent, more than any other factor, has rightly come to the fore in recent years given that a stronger talent pool enables greater institutional adapativity. even a few decades ago, much of banking and insurance used to be slightly brighter shadows of sleepy administrative factories – taking orders, processing them and doing the same again tomorrow. This has changed. Both encumbents and new entrants have seen the power of human ingenuity create whole new markets that did not exist before. Several key “genes” in the adaptive firm are associated with talent management: Is our leadership attracting or deterring the best? Do we have a culture that promotes all the other value drivers (innovation, adaptability, discipline)? Do we over-reward under-performers and under-recognise superior performers in the name of “fairness”? Do we know the alternatives open to our best people and what might motivate them to switch their energies?

Capital is as indispensable as talent, but to be attractive to investors takes a different set of attributes. unfortunately, the governance of many financial services firms has drifted off course to the extent that management priorities are mainly focused on job preservation and reward maximisation rather than on shareholder value creation – and, crucially, there is no effective corrective action from the board. With robust internal governance, the phenomenon of activist investors would not exist in its current, aggressive form. Is your firm welcoming to investors? Does your leadership “think like capital”? Or are you betting that capital is so plentiful that you don’t need to justify what you do with it?

Perhaps the most fickle and elusive of all business resources is the customer. Customers, too, have largely been neglected and even systematically mistreated by many financial services providers. The mis-selling scandals in developed countries, the pyramid schemes in emerging economies and generally low satisfaction rates among most retail customers speak for themselves. Instead of being wooed with better services and superior offers, customers are shackled by switching charges and captive products. Instead of being offered truly valuable solutions for their longer and more complicated lives, customers are often regarded as little more than a necessary evil. no wonder other species (direct/Internet innovators, retailers, telcos, software providers, healthcare and automotive companies) are invading the financial services market.


Lesson 4 – Habitats are more important than competitors

In financial services, as in biological evolution, no-one can escape the environment that they are in. research has shown that financial services revenues are driven by two fundamental factors: exogenous economic production and endogenous innovation. The former is the key factor, accounting for over two-thirds of growth. In simple terms, higher GDP/capita, higher GDP growth rates and less equal wealth distribution are all big drivers of financial services revenues. Many other factors, such as regulation, play a role too. This creates a rich diversity of finance habitats, each with very different characteristics. A key insight from our research is that habitat differentials are more important than competitor pressures in most of financial services.

Being present in the right markets is a big plus that can be managed over time. even seemingly monolithic markets (e.g. mass retail in a medium sized-economy) are actually composed of several sub-habitats, each with its own features. Large value skews are a persistent feature of most financial markets and should lead to a continuous hunt for the best habitats.

There is ample evidence that much of the demand for financial services is latent and either goes un-served or appears as self-provision. Pension provision, insurance and risk diversification are very large areas of potential demand. By contrast, when new services have been made available – often by initially small start-ups such as Capital One (credit cards), PayPal (payments) and MAn (retail hedge funds) – the take-up has been very fast.

Habitat loss is also a feature of the real world in finance. Cross-border payments in europe used to be a hugely lucrative business for commercial banks, but with the advent of the single market, this “rent” is disappearing fast. Structured products seemed like the “no-brainer carry trade” to those unfamiliar with the market, but the liquidity crisis of 2007 has clearly dealt a blow to that line of business.

�6

Lesson 5 – Buy insurance

everyone agrees that large exogenous shocks – the economic equivalents of meteor strikes and ice ages – will happen again in the future. Such shocks occur at a much higher rate than previously believed, simply because there are so many distributions in play. So-called “six-sigma events” actually occur every decade or so in some part of the financial system.

there are two ways of “buying insurance” against such shocks. the first is the most obvious and least palatable for those locked into quarterly earnings announcements: Pay a premium to someone who will cover the extreme risks in your business portfolio. Most financial services firms in the world are not only aware of these risks, they quantify, monitor and report them regularly. Hedging such risks, however, has an immediate cost to the P&L and is often dismissed as “too expensive”. In our view, boards should be much more proactive in requiring the explicit hedging of specific extreme risks in their firms. Where this works, as in Goldman Sachs’ experience in the credit crunch of 2007, it can be spectacularly rewarding for shareholders and employees.

The second type of insurance policy is to “become amphibian”. In some cases, a management team might suspect that it is the wrong species with the wrong genes and maybe the wrong habitat. The temptation in such situations is often to attempt to turn the firm into something that it is not: from a universal provider into a distribution powerhouse, from a mature economy provider to an emerging markets player, from a broker to a principal investor. Instead of committing such rash acts, it is possible to grow capabilities that are still linked to the core of the firm but create new growth options. Credit card firms need to find cheaper, more stable customer deposits. Domestic retail banks need to build a platform that is better for their customers and that can go cross-border. Life insurers need to tap into the savings wallet of their clients. Having lungs and gills can be a great insurance policy as liquidity ebbs and flows.

The above is not a formulaic recipe that, if followed to the letter, will create the financial services equivalent of homo sapiens at the top of the evolutionary tree. Indeed, a lesson from evolution is that every survival strategy has its own extinction buried deep inside it. rather, the above lessons are internally consistent guidelines for leaders who face a barrage of often conflicting advice and demands. Boards, CeOs and executive management teams who swim with the evolutionary tide are more likely to survive and thrive.


oVerVieW

evolution is not just a metaphor for the state of financial services, but an internally consistent set of processes that can be seen at work in markets past and present. It is the only plausible framework that describes the many – sometimes seemingly contradictory – aspects of the financial world over long periods.

Most of the consensus view has been shown to fall short when it comes to providing future guidance, mainly because its past reference period is too short and its assumed futures are too smooth. With all the important drivers of financial services growth, from macroeconomics to demography to innovation, the next quarter-century will not be a linear extrapolation of the last one. Indeed, the biggest drivers of all – BrIC expansion, risk transfer and high liquidity – will likely experience the highest volatility.

��THE EvoluTion of financial sErvicEs

6 COnCLuDInG reMArKS

examining the history of financial services and the macroeconomic conditions in which the industry operates yields some important insights into the current state of the industry. In certain dimensions we are little (if at all) more advanced than we were at the beginning of the twentieth century, while on other measures we are truly in uncharted waters. In terms of global integration and liquidity, for example, the world is essentially repeating the experience of Globalisation 1.0 before 1914. In terms of securitisation and the use of derivatives, on the other hand, we really are in a new world.

The key to survival for any financial services firm lies in the ability to recognise the slowly evolving long-term trends at work, while at the same time preparing for the inevitable and unpredictable shocks that will occasionally strike. Long-term trends can be as slow-moving and predictable as demographic shifts in the developed world and growth in emerging Asia. It is harder to predict when crises will come, however, and what form they will take. Only the best prepared firms will weather the storms ahead without lasting damage. Constant vigilance and adaptability are the keys to survival. Those that successfully recognise the difference between the periodic ”winters” (financial crises, bear markets and periods of low liquidity) and the epoch-defining ”ice ages” (Great Depressions and inflations) will be those that succeed.

every shock to the financial system will result in casualties. For a short period, “natural selection” will work fast to eliminate the weakest institutions in the market, which will typically be absorbed by the successful. Most crises will also usher in new rules, as legislators and regulators react and politicians mark their ground by acting to protect the consumer.

The critical point, however, is that this possibility of extinction cannot and should not be removed by excessively precautionary regulation.

As Joseph Schumpeter wrote more than seventy years ago, “This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted.” “Creative destruction” means nothing less than the disappearance of “those firms which are unfit to live”.22 Although there is much more research to be done on the long-run evolution of modern finance, we have no doubt that Schumpeter’s words remain applicable today.

22 Schumpeter(1�34),pp.254

100

BIBLIOGrAPHyAlchian, A.A. (1950), “uncertainty, evolution and economic theory”, Journal of Political economy 58: 211–222

Arnone, Laurens and Segalotto (2006), “Measures of Central Bank Autonomy”, IMF Working Paper 06/228

Bátiz-Lazo, B. (2004), “Strategic Alliances and Competitive edge: Insights from Spanish and uK Banking Histories” Business History vol. 46, no. 1 (2004), pp. 23-56

Benink, H.A. and Benston, G. J. (2002), The Future of Banking regulation in Developed Countries: Lessons from and for europe, Financial Markets, Institutions & Instruments, vol. 14, no. 5 (Dec. 2005), pp. 289-328

Blanden, Michael (1990), “europe, top savings banks: Finding common cause”, The Banker, vol. 140, no. 776 (October, 1990)

Carter, S.B., Gartner, S.S, Haines, M.r., Olmstead, A.L., Sutch, r., and Wright, G., Darwin (eds.) (2006), The Historical Statistics of the united States: Millennial edition, Cambridge university Press, Cambridge

Davies, G. (2002), A history of money: from Ancient times to the Present Day, university of Wales Press, Cardiff

Dawkins, richard (1989), The Selfish Gene, (2nd edn), Oxford university Press, Oxford

Dawkins, richard (2003) A Devil’s Chaplain: Selected essays by richard Dawkins, ed. Latha Menon, Weidenfeld & nicolson, London

Duet, D. (1986), La métamorphose des Caisses d’epargne : l’évolution des Caisses d’epargne ecureuil de leins origines à la période actuelle, Les editions de l’epargne, Paris

Goldsmith, r.W. (1975), Financial intermediaries in the American economy since 1900, Arno Press, new york

Goldsmith, r.W. (1983), The Financial Development of India, Japan, and the united States, yale university Press, yale

Gould, Stephen Jay (1989), Wonderful Life: The Burgess Shale and the nature of History, W. W. norton & Company, London

Homer, S. (1996), A History of Interest rates, rutgers university Press, Hoboken nJ

Kindelberger, C.P. (1984), A Financial History of Western europe, Allen & unwin, London

Liesner, t. (1989), One hundred years of economic statistics, united Kingdom, united States of America, Australia, Canada, France, Germany, Italy, Japan, Sweden, economist Publications, London


McKinsey Global Institute (2007), The new Power Brokers: How Oil, Asia and Hedge Funds, and Private equity are Shaping Global Capital Markets. MGI. San Francisco

Maddison, Angus (2003), The World economy: Historical Statistics, OeCD

Mitchell, B.r. (1988), British Historical Statistics, Cambridge university Press, Cambridge

Mitchell, B.r. (2003), International historical statistics: europe 1750-2000, (5th edn), Palgrave Macmillan, Basingstoke

Mitchell, B.r. (2003), International historical statistics: Africa, Asia & Oceania, 1750-2000, (4th edn), Palgrave Macmillan, Basingstoke

Mitchell, B.r. (2003), International historical statistics: The Americas, 1750-2000, (5th edn), Palgrave Macmillan, Basingstoke

Mura, J. (ed.) (1996), History of european savings banks, WissenschaftsfÖrderung der Sparkassenorganisation, Stuttgart

nelson, r.r. and Winter, S.G. (1982), An evolutionary theory of economic change, Harvard university Press, Cambridge, MA

Obstfeld and taylor (2002), “Globalization and Capital Markets”, nBer Working Paper 8846

Pohl, M. (1982), Deutsche Bankengeschichte / herausgegeben im Auftrag des Instituts für bankhistorische Forschung e.v. von seinem Wissenschaftlichen Beirat, Fritz Knapp verlag, Frankfurt

rousseau, Peter L. and Sylla, richard (2003), “Financial Systems, economic Growth, and Globalization”, in Michael D. Bordo, Alan M. tayor and Jeffrey G. Williamson (eds.), Globalization in Historical Perspective, university of Chicago Press. Chicago, pp. 373-416

Schiffer, H. F (1962), The Modern Japanese Banking System, university Publishers, new york

Schumpeter, J. (1934), The Theory of economic Development, Harvard university Press, Cambridge, MA

Sheppard, D.K. (1971), The Growth and role of u.K. Financial Institutions, 1880-1962, Methuen, London

Sterne, G. (2001), “Inflation targets in a Global Context”, Central Bank of Chile Working Paper 114

torgerson, H.W. (1954), “Developments in Savings and Loan Associations”, 1945-53, The Journal of Finance, vol. 9, no. 3 (September, 1954), pp. 283-297

veblen, t. (1898), “Why is economics not an evolutionary Science?”, Quarterly Journal of economics, vol. 12, 1898


ACKnOWLeDGMentSOliver Wyman is a leader in financial services strategy and risk management consulting. The breadth and depth of our work in financial services gives us deep insight into the issues our clients face and how to help them perform better. to complement this, we also harness the varied experience of our Senior Advisory Board members – all with distinguished careers as regulators, chief executives and academics – to enhance the pragmatic impact of our leading-edge ideas.

The members of the Oliver Wyman Senior Advisory Board are

Rolf E. Breuer, former Chairman of the Supervisory Board and Chief executive of Deutsche Bank

Mathis Cabiallavetta, vice chairman of Marsh & McLennan Companies, Inc., former chairman of the board of uBS

Henning Christophersen, former Danish Minister of Finance and eu Commissioner

Carlo Corradini, Chairman of Leonardo Italy, and member of the Board of Directors of Banca IMI

Professor Niall Ferguson, Harvard university, author of ‘The House of rothschild’ and ‘The Cash nexus’

Korkmaz Ilkorur, Founder of İlkorur Advisory Services and chairman of Bati Insurance Company

Alexander Hendrik George Rinnooy Kan, Chairman of the Social and economic Council of the netherlands (Ser) and Member of the executive Board for InG Group

Sir Andrew Large, former Deputy Governor, Bank of england

David Murray, former Chief executive of Commonwealth Bank of Australia

Emmanuel Rodocanachi, Chairman of the Supervisory Board of Salomon Smith Barney, formerly Chairman and Chief executive Officer of natexis SA

Vanni Treves, Chairman of the Board of Korn/Ferry International, The equitable Life Assurance Society, Intertek Group Plc and the national College of School Leadership

Ignacio Sanchez- Asiain Sanz vice Chairman of Banco Provincial, BBvA Chile, Banco Continental and BBvA Colombia

Charles N. Bralver, executive Director of the Master of International Business program and Center for emerging Markets enterprises, at The Fletcher School of tufts university and founding partner, Oliver, Wyman & Company

106

With more than 2,500 professionals in over 40 cities around the globe, Oliver Wyman is the leading management consultancy that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, organizational transformation and leadership development. The firm helps clients optimize their businesses, improve their operations and risk profile, and accelerate their organizational performance to seize the most attractive opportunities. Oliver Wyman is part of Marsh & McLennan Companies [nySe: MMC].

profeSSorNiAllferGUSoN

niall Ferguson is Laurence A. tisch, Professor of History at Harvard university and William Zeigler Professor of Business Administration at Harvard Business School. He is also a Senior research Fellow at Jesus College, Oxford university, and a Senior Fellow at the Hoover Institution, Stanford university. His numerous books include The World’s Banker: The History of the House of Rothschild, which won the Wadsworth Prize for Business History, and The Cash Nexus: Money and Power in the Modern World, 1700-2000, which he wrote as a Houblon-norman Fellow at the Bank of england. A prolific commentator on contemporary politics and economics, niall Ferguson is also a contributing editor for the Financial Times.”


For more information please contact the marketing department by email at [email protected] or by phone at one of the following locations:

EMEA +44 20 7333 8333

North America +1 212 541 8100

Asia Pacific +65 6510 9700

Copyright © 2007 Oliver Wyman Limited. All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman.

This report is not a substitute for tailored professional advice on how a specific financial institution should execute its strategy. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisers. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages.

This report may not be sold without the written consent of Oliver Wyman.

Oliver Wyman - Evolution of Financial Services - Dec 07

Documents

Transcript of Oliver Wyman - Evolution of Financial Services - Dec 07