global economy may 2009 www.capital-me.
com
By Dr. M S S El Namaki
A myriad of reasons have been given for the current
credit crisis and the ensuing dramatic economic
A New
episode. Practices within the investment banking
industry, lax government regulation, creative
finance, bad monetary policies and irresponsible
executives are all pointed out as culprits. Culture,
Landscape
ideology and the sheer desire to amass wealth are
also added. In the end, greed has been identified as
the underlying common denominator and the force
that transcended functions, structures and people.
he question on everybody’s mind today is
Banking After the Credit Crisis T how long it will all last and what will emerge
from this virulent force of nature.
Roots of Crisis
The crisis can basically be attributed to three trig-
gers: faulty financial instruments, bad institutional
framework and aberrant strategies.
Instruments
One of the prime instruments involved in the ongo-
ing crisis is securitization. It was the pivot in credit
volume expansion and credit risk enhancement. It is
a form of structured finance whereby financial
assets, especially those for which there is no ready
secondary market, such as mortgages, credit card
receivables and student loans, are pooled and used
as collateral for new securities. Securitization,
through highly rated mortgage backed securities
(MBSs), allowed mortgages with a high risk of
default to be originated almost at will, with the risk
shifted from the mortgage issuer to investors at
large. Securitization also meant that issuers could
repeatedly relend a given sum, greatly increasing
their fee income and dodging default risk.
Investment banks assumed a key role in securitiza-
tion.
Institutions
A shadow banking system devoid of regulation dis-
regarded common sense and assumed a high risk
mantel. Investment banks, as the prime players with-
in the shadow banking system, went into massive
debt and invested the proceeds into MBSs, essen-
tially betting that house prices would continue to rise
and that households would continue to make their
mortgage payments. What they did was borrow at
lower interest rates and invest the proceeds at high-
48
One of the prime
mistakes made
by contemporary
bank
management is
focus on current
revenue and
making that the
base for mobility
and rewards.
er interest rates, or practice financial leverage. This
is a strategy that would work under normal market
conditions or conditions where real estate prices
assume a stable upward trend. The opposite
occurred. Result: mortgage default and collapse in
the value of MBSs.
Losses in MBSs among investment banks resulted
in a decline in their operating capital and a loss of
confidence of creditors. Three investment banks col-
lapsed: Bear Stearns, Lehman Brothers and Merrill
Lynch.
Strategies
Speculative leverage had become a mainstream
strategy for banking and insurance institutions, with
speculation and greed replacing sound business
strategies and becoming the prime force within
financial markets. Three types of borrowers con-
tributed directly towards the accumulation of insol-
vent debt: The hedge borrower who expected to
make debt payments from cash flows from other
investments; the speculative borrower who bor-
rowed believing that the appreciation of the value of
the assets would be sufficient to refinance or pay off
their debt and who did not have sufficient resources
to repay the original loan; and the Ponzi borrower
who relied on continually rolling over the principal
into new investments. Speculation reached epidem-
ic levels in the U.S.
The End of the Tunnel
The following table projects forecasted values for
GDP growth, unemployment, consumption expendi-
ture, investment expenditure and current account
balance for a few key economies and two crucial
years: 2010.
The countries and areas involved are the U.S., the
EU, Japan and China.
49
 global economy may 2009 www.capital-me.com
Table (1): Key economic projections for the U.S., EU, Japan and by a pool of talent that they have managed to
China for the year 2010; the official view. assemble from the leftovers of the U.S. carnage.
The independence of American investment banks
Growth indicators 2010 today is in doubt; reasons start with the risk of insol-
USA EU Japan China vency. Investment banks have higher leverage than
GDP growth percentage 0.0 * -0.3* -0.5* 8.5*** other banks (in America, at least), which worsens
Unemployment 10.3* 11.7* 5.6* the impact of falling asset values. They also lack the
Real gross fixed capital stable earnings streams of commercial and retail
formation percentage -3.3* -2.1* -1.9* 43%**** banking. When the market for structured finance
change from last year revives, it will be smaller and less rewarding than
Current account before, and investment banks will learn to orient
balance percentage GDP -3.6** -1.1** 3.9 10.0 *** towards their prime core competencies, i.e., corpo-
Actual vs. potential GDP -8.8* -7.2* -9.6* n/a rate finance, advisory, brokerage and asset man-
agement.
Sources:
(*) OECD March 2009 projection. The Future of Private Equity and Hedge Funds.
(**) IMF in constant 2007 dollars. Estimates were made before the credit crisis. Private equity is dependent on leverage and attrac-
(***) Rate oscillates almost daily. These figures were given by the Chinese govern- tive deals and both are under pressure in the current
ment in late March 2009. environment. The future will only bring an escalation
**** Estimate. of this situation. And regulation may not be far off.
Private equity was, for some time, in fashion. The
principle of opportunistic leveraged buyout of busi-
It does not take much analysis to conclude that the nesses and rapid and enhanced sale of restructured
outlook is dark and economic contraction is a com- and presumably healthy companies caught fire.
mon denominator for the U.S., Japan and the EU. Funds saw massive growth in number, volume, size
The most striking figures are those of actual vs. and coverage and the figures were staggering at
potential GDP, where the figures vary only slightly times. Participation in private equity activities was
between the three countries and reflect a failure to widespread, with the U.S. heading the list.
exploit the resource base of those countries. China, Buying companies with the help of masses of debt
in contrast, comes out quite well in terms of growth made the private equity industry particularly vulnera-
levels and expectations. ble to both credit shortage and the declining value
of its portfolios. The argument that leverage
The Future of Investment Banking enhances returns to shareholders proved false.
The U.S. investment banking industry will experience Private equity firms, as a whole and over a period of
dramatic contraction and new entrants − possibly three decades, achieved an average annual return
from the Gulf and China − will assume a key global equal to or less than that of Standard & Poor’s 500-
role. The industry will also be regulated. stock index. The industry is very likely to witness
U.S. investment banks have depended heavily on fund withdrawal as well as rigorous regulation
short-term funding and high leverage to generate The Future of Universal Banking
exceptional return on equity. Good times proved Universal banking will expand, first as an escape
them right, but bad times, compounded by poor risk mechanism for investment banks and second as a
management, judgment and decision making, safer, more manageable version. The U.S. 1933
spelled disaster. The future will see far-reaching Glass-Seagull act, which separated investment
change in both the function of and participants in banks and commercial banks, was repealed in
investment banking in the U.S. and, most likely, 1999. Universal banks, which marry investment
Europe. The function will continue, be it in a modified banking and deposit taking, will ascend. For regula-
scale and form. There are no major, independent tors, larger, diversified institutions are more stable
investment banks left in the U.S. today and the than investment banks. The risks are lower, but it
future carries low probability of the emergence of as goes without saying that they do not go away. And
strong or powerful players as those that once exist- deposit funding is cheaper than wholesale funding in
ed. Novel entrants from places like China and the part because those deposits are insured. For share-
Gulf States will emerge. Their entry will be assisted holders, too, the universal bank may offer comfort.
50
The Future of Central Banking The Future of Hedge Funds
Central banks will resort to new vehicles to stimulate The American hedge fund industry will seriously
The U.S.
liquidity and credit. These will rely on direct-to-mar- suffer from massive investor redemptions. investment
ket transfers. Central banks’ practice of regulating Regulation may be on the horizon. Steep losses banking industry
economic activity by adjusting the level of the inter- and a series of high-profile collapses put American will experience
est rate may not always work, as witnessed in hedge funds at the heart of the credit crisis, forc- dramatic
Britain in recent months. The limit is the level of this ing hedge funds to reconsider operations and take contraction and
new entrants −
interest rate. Once the base rate gets close to zero, on a more defensive profile. U.S. institutional
possibly from the
that approach no longer works. investors have been withdrawing funds from hedge Gulf and China −
Quantitative easing measures are a new approach funds to meet commitments to private equity, will assume a key
undertaken by the Bank of England in order to raise although private equity portfolios are not perform- global role.
the monetary base or cash and commercial bank ing that much better. The migration of disillusioned
reserves. Quantitative easing is unchartered territo- investors has reached critical levels, with an out-
ry. The Bank of England will buy government securi- flow of $152 billion in the fourth quarter of 2008
ties as well as private assets such as commercial reducing total industry assets to $ 1.4 trillion at the
papers, to the tune of $105 billion, and will pay for end of 2008. The Madoff affair also simulated
this with its own money (contrary to the practice of redemption. Current estimates put industry hold-
financing transactions by the issue of Treasury bills). ings at less than $ 1 trillion, compared with $ 2.7
The measure would stimulate cash flow, as the Bank trillion in June 2008. Further decline in fund hold-
of England would pay for the purchases by crediting ings may lead to a decline in total industry holdings
the accounts of commercial banks, but it is basical- to $ 950 billion.
ly creating money. And inflationary fears may be a It is striking that investors who tried to redeem
faint step away. their funds late in 2008 found that their hedge fund
investors had temporarily limited or barred exit.
The Future of Bank Management
Banks will be managed differently, with greater
emphasis on long-term returns instead of short-term Dr. M S S El Namaki
revenues. teaches and consults
One of the prime mistakes made by contemporary on strategic thinking,
entrepreneurship and
bank management is focus on current revenue and international business.
making that the base for mobility and rewards. He is past founder and
Although longer-term profits may never have materi- dean of the Maastricht
School of
alized, short-term revenue-rooted rewards were Management,
granted. Change is taking place and in several direc- Maastricht, The
tions. First, banks are told by governments that prof- Netherlands (1984-
2002). El Namaki has
its matter more than revenues. Put differently, exec-
developed and
utive performance should be measured by profit introduced
realization over a given period rather than instanta- management degree
neous book revenue generated at the moment of programs into no
fewer than 25
the transaction. Banks are also told compensation countries, including the
should be based on a return on equity over a justi- Netherlands, China,
fied period of time, not current year revenue. Egypt, Brazil, Poland,
Canada and Indonesia.
In the process, banks are learning that true chem- He has held executive
istry should provide a decision base, i.e., leverage positions with Philips
works when the curve is upwards and does not (Eindhoven), McKinsey
(London and Dar es
work, to a disastrous extent, when the curve is
Salaam) and Time Inc.
downwards. Also, diversified and recurring revenue (Amsterdam). El
streams work wonders when the tide is down. And, Namaki’s book
finally, risk management should become a board Strategy and
Entrepreneurship in
responsibility. Lower-level risk taking could jeopar- Arab Countries was
dize the entire organization. published last year.
51