The Future of Finance

A New Model for Banking and Investment

Moorad Choudhry, Gino Landuyt

• Publisher: Wiley
• Year: 2010
• Print ISBN: 9780470572290
• eBook ISBN: 9780470906460
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

New banking and investment business models to navigate the post-financial crisis environment

The financial crisis of 2007-2008 has discredited business models in the banking and fund management industries. In The Future of Finance, Moorad Choudhry and Gino Landuyt argue that banks must realign their business models, implying a lower return-on-equity; diversifying their funding sources; and increasing liquidity reserves. On the investment side, the authors discuss how diversification did not reduce risk, but rather amplified it, and failed to stabilize returns. The authors conclude that the clear lesson from the crisis is to know one's risk. A lesson that is best served by concentrating on assets and sectors that you understand.

• Examines the weaknesses in the business models of many institutions, as well as the theoretical foundation for professionals in the field of finance
• Identifies the shortcomings of Modern Portfolio Theory
• Addresses how investment managers can find new strategies for creating "alpha" and why they need to re-vamp their fee structures

Filled with in-depth insights and practical advice, The Future of Finance will provide bankers and investment managers with a guide to realigning their businesses in order to prosper in the post-crisis financial markets.

PART ONE

A Review of the Financial Crash

Part One of the book is a wide-ranging review of the 2007-2009 financial crisis. It looks beyond the headlines and the media hype to present a full analysis of the factors leading to the crash of 2007 and the banking crisis of 2008, and the interaction between these factors. An understanding of these factors is vital as the first step to designing a banking and investment model that is better placed to withstand the impacts of the next crash in the economic cycle.

CHAPTER 1

Globalization, Emerging Markets, and the Savings Glut

The purpose of this book is to explain the financial crisis from a banking point of view, and to offer solutions for improvement such that the financial industry is better placed to withstand the impact of future crises. Surprising as it may seem, the topics of globalization, emerging markets, and the savings glut cannot be excluded from this book. Often in the search for the causes of the financial crash of 2007-2009, globalization and the role of the Asian and oil-exporting countries are underestimated. In many analyses of the crisis, the successive emerging-market crises over the past decade and the undervalued currency of emerging-market economies gets credited with, at best, only a secondary role in the crisis.

This is to miss a fundamental aspect and causal factor of the crash, and one that had been building up for over a decade. We want to phrase it even more strongly. One of the biggest challenges that world political leaders will be facing in the next decade is to address the global imbalances that have been created over the previous decade. If they do not succeed in this, then even the most robust banking regulation will not be sufficient to protect the financial industry from another financial crisis, the effects of which could be even worse than the one just experienced. In saying this, we recognize the role emerging markets played and are still playing as pivotal to the crash.

GLOBALIZATION

In identifying the responsibility of these emerging-market economies we need to go back to the very beginning of globalization. As we illustrate, the impact of globalization was detrimental in the way it drastically changed the landscape of financial markets. The seeds of globalization were planted at the end of the 1970s. Prior to this the United States possessed something more akin to an autarkic economy than a truly integrated open economy (the United Kingdom, for example, has always been more of an open trading economy than the United States). Apart from dependence, to some extent, on imported oil, the U.S. economy was financed by its own pool of money.

The collapse of the Bretton Woods currency arrangement and the oil shock of 1973-1974 were the first steps leading to an integrated global economy. A major event in the opening up of financial markets in the United States was the broadening of the investment guidelines of pension funds. These were allowed to invest in smaller mid-cap companies, which was the spark for the growth of venture capitalism. The introduction of 401(k) pension schemes freed up more capital and by the mid-1980s, during the Reagan administration, cross-border capital flows started to accelerate. The fall of the Berlin Wall and the collapse of communism in general opened up trade opportunities across the globe, and companies and banks started to operate more internationally. The impact of the implosion of communism was significant, as it released a peace dividend as capital previously allocated to defense spending during the Cold War was now able to be invested in free markets. This peace dividend contributed to a liberalization of international trade and increased productivity.

The banking industry recognized the opportunity of this new environment and started setting up branches and subsidiaries in foreign markets. U.S. and European banks were particularly welcome in emerging economies because in many cases a developed banking infrastructure was not in place in these countries, and Western banks were welcomed as a source of expertise. This state of affairs continues to this day, as evidenced by the numbers of expatriate bankers moving from the city of London and Wall Street to banks in the Middle East and Asia. The expansion of Western banks was also facilitated by the development of technology and the use of advanced information technology (IT) infrastructure. For instance, electronic money transference enabled almost instant funding and created a market of interbank liquidity.

During the Clinton administration globalization spread further and deeper as free trade was enhanced by removing many protectionist barriers. Globalization flourished as markets opened up; new capital was made available to do business with Latin America, Asia, and Central and Eastern Europe.¹

A paradox of this development was that, by opening their borders to free trade with the rest of the world, these countries created potential vulnerabilities. They embraced the free market principle as it gave them a way to get out of isolation and poverty by accepting the money that came from international lenders. However, simultaneously they built up a substantial amount of foreign debt. Governments were not ready to enter what David Smick has called this “ocean of liquidity.”²

A SERIES OF EMERGING-MARKET CRISES

Free capital flows set the stage for various emerging-market crises such as the Asian currency crisis of 1997-1998. Each crisis was faintly similar: The emerging economy suffered either a full-scale banking crisis or a currency crisis or both. The reasons behind these crises are described most accurately by Frederic Mishkin³ and Martin Wolf.⁴

First of all, as mentioned earlier, governments were unprepared for the impact of the liberalization of free markets and made clear policy mistakes. Opening up one’s borders while one’s local banking system is still undeveloped results in a highly leveraged debt buildup as well as a deterioration of loan origination standards. A surfeit of money tends to produce this situation. Many of the loans originated in the local banking systems defaulted. In any situation, as banks start experiencing a rise in bad loans, they increase write-downs and loan loss provisions, and withdraw from lending. This then has a knock-on effect on the economy, and leads to a slowdown in the economic growth process. This is the second phase described in Frederic Mishkin’s scenario, the buildup toward a currency crisis. During this phase the government has to step in and come to the rescue. However, for emerging economies their financial strength as a lender of last resort (LOLR) is limited, and often such governments undertake the process with help from the International Monetary Fund (IMF). A drop in public spending is the inevitable result of this process.

Investor confidence (by local residents and foreign investors) disappears rapidly at this point, and this triggers the third phase: the currency crisis, once most investors withdraw their money from the country. The central banks of these emerging countries are then faced with a stark choice. Either they have to raise interest rates sharply to support their currency, which will push most people who are in debt into default, or they have to stop intervening and allow their currency to devalue, which will produce inflation and ultimately also cause defaults where much of the borrowed money is in foreign currency. The final phase is the result of the choices to be made in phase three: an unavoidable deep economic recession.

Crises like this have occurred on a regular basis over the past three decades. A study from Hutchison and Neuberger (2002) showed that between 1975 and 1997, 33 bank crises, 51 currency crises, and 20 “twin crises” took place in emerging economies.⁵

A look at the crisis in Thailand in 1997 confirms that events here followed almost exactly the path described by Mishkin. Paul Krugman provides an in-depth analysis of the Asian crisis in his book, which we summarize here.⁶

In the first instance, foreign investors were tending to avoid Latin America after the so-called Tequila Crisis of 1994. This was the series of events in which Mexico suffered a severe currency crisis that year, in part arising from policy mistakes made by President Carlos Salinas de Gortari’s government. They focused instead on Asia, and Thailand in particular, which was in the process of converting from an agricultural into an industrial economy. The industrial sector was expanding rapidly, financed by foreign money, to the point where Thailand became an “Asian tiger” with almost double-digit economic growth rates year on year. Foreign banks were feeding this expansion with foreign currencies that were converted immediately into Thai baht (THB), necessary because local entrepreneurs could not use Japanese yen (JPY), U.S. dollars (USD), or German deutsche marks (DEM) to pay workers or buy property.

Due to this increased demand the THB started to appreciate in value. But the Thai central bank wanted to prevent this and keep the THB stable against other currencies. In fact this turned out to be a significant mistake because it stimulated credit growth. In order to keep the THB stable the Thai central bank constantly had to sell its own currency and buy foreign currencies, generally USD. As a result the money supply in THB increased but also the foreign currency reserves of the central bank started rising. A speculative bubble was building up, but instead of halting the support of its own currency the central bank of Thailand (as did all central banks in the region) began to limit the capital inflow. This was done by buying back in the market the THB that they had just sold. In essence the central bank was turning on the money printing press. This acceleration in the money supply, M2, created higher interest rates and rising inflation, which was an incentive for local companies to start borrowing even more in foreign currency, which was much cheaper. The equation⁷ GDP = M2 × V was in full force and the central bank was not wise to the fact that the economy was overheating rapidly.

This development could have been prevented if the currency support had been wound down in time. This did not happen. As inflation rose wages also rose, which lowered productivity and also made exports more expensive. Consequently, exports fell, and a current account deficit was created.

An important element in this lending process was the existence of a middle man between the foreign lender and the local borrower, in the form of a so-called finance company. This was not a local bank but a facilitator that converted the foreign loan into the local currency and determined the interest rate to the borrower. Such firms dominated the lending business. As these finance companies did not operate like a classic bank, where the lending is backed by deposits, they were less disciplined in their loan origination processes. They also expected loan defaults to be covered by the government and ultimately the taxpayer. This moral hazard itself breeds a dangerous complacence, as we explain in a later chapter.

At a certain point, as is the case with all bubbles, investors started losing confidence and withdrew. The borrowing from abroad decreased rapidly and created an ...

Table of contents

• Title Page
• Copyright Page
• Dedication
• Foreword
• Preface
• Epigraph
• Introduction
• PART ONE - A Review of the Financial Crash
• PART TWO - New Models for Banking and Investment
• Notes
• References
• About the Authors
• Index