What Does the Future Hold for Investment Banks?
The events unfolding in the global financial arena have been unprecedented in the history of finance and are a concern to every economy where goods are produced, services are rendered and value is created through this exchange. Rather remote institutions, such as the Nobel Foundation, have also felt the impact of these events. The Nobel committee awarded the Nobel Prize for Economics to Paul Krugman who has advocated an interventionist capitalism model where relationships between true economy and the finance world is looked at in detail by the federal banks, and the authorities are perceived as a more preventative machine than as a post-event analysis and penalty imposing institution.
This is the second time in the history of capitalism – (the first being the Great Depression of 1929) – that the US Senate is discussing in detail means to overcome the challenges posed by what began with the sub-prime crisis. It is believed that falling mortgage prices triggered the catastrophic events of recent months worldwide. In reality, the financial over-engineering and structured products that were hiding the true risk associated with assets created this mayhem. It is the first time in modern history that we are witnessing an economic crisis of this scale.
In an unprecedented move, governments across the world embarked on initiatives to create funds to support valuation of money market instruments and to ease liquidity in the system. They are taking measures to ensure credit quality does not deteriorate further. For the first time in the history of financial economics, a synchronised bailout of banks and financial intermediaries is being planned and executed with the same vigor with which a government protects and defends its borders against invasion.
It is the first time in the history of trading where the regulators all around the world are looking into what appeared to be a general practice of short selling. To that extent, ‘bear’ and ‘bull’ concepts will be redefined. On a lighter note, the new definition of a bear could be the person who takes government approval to sell early to minimise the loss. To put things in perspective, most of the investment banks have lost their top five positions based on the net capital calculations in the institutional banking space. Furthermore, the independence of leading institutional banks is now restricted primarily due to the approved Bailout Agreement. Lehman Brothers and Bear Stearns – two of the largest capital markets firms-no longer exist. Together they constituted over US$42bn in net worth. The finance world will certainly miss them.
What will the structure of investment banks be in years to come and how will it impact spending on IT and IT-enabled services? Considering these are the organisations that first moved significant work offshore and built captives, as well as offshore development centres within their service provider organisations, these are important questions that we will collectively need to find an answer to.
I would like to take this question by looking into a more fundamental issue – do we believe financial intermediaries, especially investment banks whose primary business caters to lead management, structured finance and trading, will remain the same or more importantly will they survive this crisis and continue to exist? And my answer is most definitely ‘yes’ to both questions.
In addition to my personal belief in the free economy, I believe investment banks as institutions have a significant role to play and they are critical to any market”s economy. As long as the fundamental principle of economics holds good, households will save and industries will consume the savings to produce goods and services for consumption by households, remains the same, the role for intermediaries will continue in years to come. Will they remain similar to what we have seen them as until now? Yes, but probably not as big. Will they offer the same services with the same or similar asset class comprised of all instruments including structured products? Most certainly not. Credit default swaps and credit-based derivatives product innovation will come under the microscope both from internal and external risk managers.
Insurance companies that used to underwrite these products to get a better credit rating will no longer touch these instruments. The US Securities and Exchange Commission (SEC), the UK’s Financial Services Authority (FSA) and federal and central banks around the world will increasingly scrutinise off balance sheet transactions and will have a say about the nature of business being carried out or any innovation in financial markets. Risk and risk mitigation from proactive initiatives will be the dominant theme for the next few years. More regulations will be introduced for risk measurement emerging from market practices. If you remember, the Enron debacle was one of the most important drivers in implementing the Sarbanes-Oxley Act (SOX), which underpinned the importance of disclosure of accounts and internal control systems. I believe 2009 will be the year of financial regulations covering all intermediaries and their roles in an orderly financial world.
What is interesting to note is that regulations and interventions may bring upon consolidation within this space. If you look at US markets today, there are about 8,000 banks and 7,500 credit unions serving a population of 305 million. This capacity is definitely high in an age where banking touch points are now getting as close as the phone. In addition, the fact that a majority (about 80%) of the population lives in urban areas creates an unfavourable environment for banks to make healthy margins and remain competitive. It is my belief that consolidation and focus on improving service quality will further propel changes within the financial intermediaries’ operations and business.
From an information and technology perspective, I believe, in the short- to medium-term (the next 24 months), investment into this space will decline by about 15%. Considering that in the last five years, investment banking organisations have continuously improved their operational efficiencies there may not be further room available for drastic reduction without impacting the core business. For customers, asset class choice may become restricted. However, the fact remains that these organisations will need to cater to the needs of trading and trading related services of their customers who are part of the real economy. They still need to trade, settle and account for it, however, they need to hold the instruments within their custody.
Though the challenges that lie ahead for investment banks are significant and daunting, it has not changed the need for investment banking services. The investment bank’s role may be slightly different after 2009. Their world, which has hitherto been propelled by an unprecedented exposure, will be far more orderly. No doubt resilience built over a period of time will help troubled institutions to tide over the crisis and come out stronger than before.