Long Range Planning 42 (2009) 588e613
http://www.elsevier.com/locate/lrp
Economic Drivers of Structural Change in the Global Financial Services Industry Ingo Walter
Consolidation has been a fact of life in the financial services sector in recent years, and these structural changes in the industry have created the ample strategic turbulence that has confronted senior management teams and boards of banks, insurance companies, asset managers and securities firms. The drivers include advances in transaction and information technologies, regulatory changes, geographic shifts in growth opportunities, and the rapid evolution of client requirements, which have obliged most financial firms to rethink their roles as intermediaries. Many have been acquired, while others have become consolidators, sometimes damaging their own shareholders’ interests in the process. Financial sector reconfiguration is likely to accelerate as a result of the global market turbulence that began in 2007, with governments either forcing or encouraging combinations of stronger and weaker banks in an effort to stem the crisis. In the process, financial firms that are ‘systemic’ in nature and had a major role in creating the crisis are likely to come out of it with even larger market shares e a development that is not likely to be healthy for the financial system going forward. Given the levels of socialization of risk represented by the widespread use of public guarantees to firms judged too big or too interconnected to be allowed to fail, how will the associated risk of moral hazard be addressed, and by what types and levels of regulation? What will be the effects - for the shareholder, and for society as a whole? And can a version of ‘the polluter pays’ principle, developed to counter environmental market failure, be employed to promote financial market stability going forward? Through it all, the underlying drivers of global financial intermediation remain basically unchanged, and will reassert themselves once the hurricane has passed. The purpose of this article is to provide a helicopter overview of the key strategic issues that drive strategic successes and failures, and of the empirical evidence available so far, with the aim of answering some key questions. Has consolidation represented a wise choice for the industry? Has bigger - or broader - turned out to be better? Or has it merely served to create 0024-6301/$ - see front matter Ó 2009 Elsevier Ltd. All rights reserved. doi:10.1016/j.lrp.2009.09.003
a bigger, broader crisis? Along the way, the article provides some sensible frameworks, or roadmaps, of financial intermediation economics that firms can apply in thinking through their own strategic positioning and execution. Ó 2009 Elsevier Ltd. All rights reserved.
The financial landscape e an overview Few industries have encountered as much ‘strategic turbulence’ in recent years as the financial services sector. In response to far-reaching regulatory and technological change, as well as important shifts in client behavior and the globalization of specific financial intermediation functions, the organizational structure of the financial services industry has been profoundly displaced, and there remains a great deal of uncertainty about the nature of any future equilibrium in its contours. This article assesses the factors that appear to be driving structural reconfiguration and its consequences for competition in the financial services sector. The strategic options open to financial firms in responding to - and anticipating - structural change are examined, together with the factors that seem to drive competitive performance with respect to market share and profitability.
The dynamics of financial intermediation The central components of any model of a modern financial system are the variety of conduits through which the financial assets of the ultimate savers (consumers, businesses or governments) flow towards the liabilities of the ultimate users of finance, both within and between national economies. This involves alternative and competing modes of financial intermediation, or ‘contracting’, between counterparties in financial transactions. Figure 1 gives a guide to thinking about financial contracting and the role of financial institutions and markets, summarizing the financial process (flow-of-funds) among different sectors of the economy in terms of underlying environmental and regulatory determinants or drivers as well as the generic advantages needed to profit from its three primary linkages: Fully intermediated financial flows: Savings (the ultimate sources of funds in financial systems) may be held in the form of deposits or alternative types of claims issued by commercial banks, savings organizations, insurance companies or other types of financial institutions that finance themselves by placing their liabilities directly with the general public. These institutions ultimately use these funds to purchase assets issued by non-financial entities such as households, firms and governments. This is denoted as linkage A in Figure 1. Investment banking and securitized intermediation (linkage B): Savings may be allocated directly (or indirectly via fiduciaries and collective investment vehicles) to purchase securities publicly issued and sold by various pubic- and private-sector organizations in domestic and international financial markets; Direct-connect mechanisms between ultimate borrowers and lenders (linkage C): Savings surpluses may be allocated to borrowers through various kinds of direct-sale mechanisms, such as private placements, usually involving fiduciaries e including hedge funds and private equity funds - as intermediaries. Ultimate users of funds comprise the same three segments of the economy - the household (consumer), business and government sectors. Consumers may finance their purchases by means of personal loans from banks or by loans secured against purchased assets (hire-purchase or installment loans). These may appear on the asset side of the credit institutions’ balance sheets for the duration of the respective loan contracts on a revolving basis, or they may be sold off into the financial market in the form various kinds of securities backed by consumer credit receivables; Long Range Planning, vol 42
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ENVIRONMENTAL ENVIRONMENTAL DRIVERS DRIVERS
INFORMATION INFORMATION INFRASTRUCTURE: INFRASTRUCTURE:
Information InformationAdvantages Advantages Interpretation InterpretationAdvantages Advantages Transaction Transactioncost costAdvantages Advantages
Market MarketData, Data,Research Research Ratings, Ratings,Diagnostics Diagnostics Compliance Compliance
TRANSACTIONS TRANSACTIONS INFRASTRUCTURE: INFRASTRUCTURE: Payments, Payments,Exchange Exchange Clearance, Clearance,Settlement Settlement Custody Custody
A DIRECT INTERMEDIATION (Banks, Thrifts, others)
Deposits & Certificates
RISK MANAGEMENT
SOURCES SOURCES OF OF FUNDS Households Corporates Governments
Loans & Advances
Risk Transformation (Swaps, Forwards, Futures, Options)
Brokerage Trading Brokerage &&Trading Proprietary/Client -Driven
Origination ASSET ASSET MANAGEMENT MANAGEMENT Collective Collective Investment Investment Vehicles Vehicles
Securities Investments
B INVESTMENT BANKING (Securities Broker/Dealers)
Distribution
Securities New Issues
USERS USERS OF OF FUNDS FUNDS Households Households Corporates Corporates Governments Governments
C DIRECT CONNECT LINKAGES (Hedge funds, Private Equity funds etc.)
Figure 1. Financial Intermediation Road Map
Corporations may borrow from banks in the form of unsecured or asset-backed (straight or revolving) credit facilities and/or may sell debt obligations (for example commercial paper, receivables financing, fixed-income securities of various types) or equities directly into the financial market; Governments may likewise borrow from credit institutions (sovereign borrowing) or issue securities directly. Borrowers such as corporations and governments can also privately issue and place their obligations with institutional investors, thereby circumventing both credit institutions and the public debt and equity markets. Consumer debt can be repackaged as asset-backed securities and sold privately to institutional investors. In the first mode (A) of financial contracting, depositors buy the ‘secondary’ financial claims or liabilities issued by credit institutions, and benefit from liquidity, convenience, and safety through the ability of financial institutions to diversify risk and improve credit quality by professional managing and monitoring their holdings (both debt and equity). Savers can choose from among a set of standardized contracts and receive transactions services and interest. In the second mode (B) of financial intermediation, investors can select their own portfolios of financial assets directly from the various publicly issued debt and equity instruments on offer. This may provide a broader range of options than standardized bank contracts, and permit larger investors to tailor their portfolios more closely to their objectives, while still achieving acceptable liquidity through rapid and cheap execution of trades e aided by linkages with banks and other financial institutions that are part of the domestic payments mechanism. Investors may also choose to have their portfolios professionally managed (for a fee) through various types of mutual funds and pension funds (shown as collective investment vehicles in Figure 1). In the third mode (C) of financial intermediation, institutional investors buy large blocks of privately issued securities. While they often face a liquidity penalty e due to the absence or limited availability of a liquid secondary market e they are also rewarded by a higher yield. On the other hand, directly placed securities can be specifically ‘tailored’ to match issuer and investor requirements more closely than can publicly issued securities. Market and regulatory developments (e.g. SEC Rule 144A in the US) have added to the liquidity of some direct-placement markets. Hedge funds have also become key players as intermediaries - for institutions as well as wealthy individuals - in making use of a broad array of strategies that attempt to find mis-valued assets which can be held or sold short e often on a highly leveraged basis e while limiting investors’ exposure to broad market movements. Private equity firms access the same cohort of institutional 590
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and wealthy individual clients in limited partnerships that acquire controlling stakes in public companies, take them private, restructure their finances (usually by adding leverage) and operations, and later sell them back to the public market in an initial public offering (IPO) or divest them to other companies in ‘trade sales’. Value to ultimate savers/investors, inherent in the financial processes described here, accrues in the form of a combination of yield, safety and liquidity. Value to ultimate users of funds accrues in the form of a combination of financing cost, transactions cost, flexibility and liquidity. This value can be enhanced through credit backstops, guarantees and derivative instruments such as swaps (mainly interest rate, currency and credit default swaps), forward rate agreements, caps, collars, futures and options. Markets can also be linked functionally and geographically, both domestically and internationally. Functional linkages permit bank receivables, for example, to be repackaged and sold to nonbank securities investors. Privately placed securities, once they have been seasoned, may be sold in public markets. Both private equity firms and hedge funds rely on other forms of financial intermediation (bank loans, bond issues, IPOs, etc.) to carry out their functions. Geographic linkages make it possible for savers and issuers to gain incremental benefits in foreign and offshore markets, thereby enhancing liquidity and yield or reducing transaction costs.
[Financial] intermediation processes are highly sensitive to the economic, technological and regulatory environment. It should be noted that the intermediation processes depicted in Figure 1 are highly sensitive to the economic, technological and regulatory environment. The macro growth setting will clearly affect domestic and cross-border financial flows, and the action in recent years has shifted to emerging markets, which are at the same time developing viable financial markets that will reduce the traditional dominance of commercial banks. Equally, domestic and global volatilities in exchange rates, interest rates and equity prices will drive the demand for a range of financial products, notably derivatives. Technological change is equally important in an industry where information and transaction costs play a key role, affecting both financial product characteristics and the efficiency of financial processes. Any financial intermediation is highly sensitive to regulatory change in response to public concerns about the systemic effects of financial failure and the impact of financial market practices in terms of efficiency and fairness. Given this, apparently small regulatory changes can have significant impacts on the direction and magnitude of global financial flows. Shifts in intermediary market shares There have been striking developments over the past several decades in intermediation processes and institutional design, across both time and geography. In the United States ‘commercial banks’ e institutions that accept deposits from the pubic and make commercial loans e have seen their market share of domestic financial flows between financial system end-users decline from about 75 per cent in the 1950s to less than 25 per cent today. In Europe, too, it is declining, although less dramatically, with the share of financial flows running though banks’ balance sheets continuing to be well over 60 per cent, while in Japan - as well as much of the rest of Asia - banks continue to control over 70 per cent of financial intermediation flows. Most emerging market countries cluster at the highly intermediated end of the financial spectrum, but in many of these economies, too, there is also factual evidence of declining market shares of traditional banking intermediaries. In short, classic banking functionality has been in more or less long-term decline, worldwide, in favor of capital markets. Long Range Planning, vol 42
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classic banking functionality has been in long-term decline, worldwide, in favor of capital markets. Where has all the money gone? Where has all the money gone? Disintermediation, as well as financial innovation and linkages that have become increasingly global in nature, have redirected financial flows through the securities markets. Ultimate savers increasingly use fixed-income and equity markets directly and also through fiduciaries that, through vastly improved technology, are able to provide substantially the same functionality as classic banking relationships e immediate access to liquidity, transparency, safety, and so on e coupled with higher rates of return. The one thing they cannot guarantee is settlement at par, which in the case of transactions balances (for example money market mutual funds) is mitigated by portfolio constraints dictating high-quality, short maturity financial instruments. Ultimate users of funds have benefited from enhanced access to financial markets across a broad spectrum of maturity and credit quality using both conventional and structured financial instruments. Although market access and financing costs will normally depend on the current state of the financial markets, credit and liquidity backstops (whereby banks agree to lend in case funds cannot be raised in the bond market) can in many cases be provided. Within the fiduciary sector, open-end mutual funds (both in defined-contribution pension plans and as savings, investment and transaction vehicles) have turned out to be one of the most successful financial innovations of all time e at the end of 2007 mutual fund investments amounted to about $9 trillion in the United States alone. More recently, closed-end vehicles (in the form of hedge funds) have had a spectacular run, with some $1 trillion invested at the end of 2007 worldwide. Originally launched as true hedge vehicles (for example, taking offsetting long and short positions in various equities and potentially outperforming the market as a whole, or betting on convergence of values in market anomalies), the term today essentially covers a broad range of speculative investment vehicles from macro funds to merger arbitrage. In persistently seeking misaligned values, hedge funds contribute to market efficiency and help to eliminate these misalignments in the process, which perhaps explains the gradual decline in the returns to their investors. Their unregulated nature has come under pressure due to SEC and other regulators’ concerns about their market practices and the systemic risks which might ensue. But hedge funds have evolved into a major client base for financial intermediaries in areas such as secured lending and prime brokerage, and some financial intermediaries are among the major hedge fund managers, raising anxieties about potential conflicts of interest.1 Global assets under management in both mutual funds and hedge funds declined significantly during 2008 and 2009 as a result of global financial turbulence during those years. Private equity firms are classically organized around a cluster of special-purpose limited partnerships run by their principals, who also invest as general partners in the funds they manage, alongside a limited number of qualified (wealthy) individuals and institutional investors who will share in any gains or losses e but will also, in the meantime, pay hefty management fees. With distinctive financial and industry expertise, and investors who are locked-in for several years, private equity firms search for what they consider materially undervalued assets e mismanaged public companies, startups in promising industries, public-sector privatizations, corporate spin-offs, or corporations coming out of bankruptcy. As noted earlier, they ostensibly add value by leveraging the capital structure of the firms they invest in and reduce ownership-management problems in target corporations, with the former highly dependent on plentiful, cheap credit. For established businesses, this restructuring process usually involved focusing intensively on improving cash-flows and reworking the financial structure to increase leverage e which wasn’t too difficult in times of global liquidity and cheap credit e as well as closing obsolete plants, streamlining production processes, improving products and services, unloading non-core businesses, and other related initiatives to make the business more valuable. Most (but not necessarily 592
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all) top management and the board will usually be replaced, and e in the absence of scrutiny by the public markets e the private equity firm will single-mindedly dominate both management and governance processes. If all goes well, an exit will be found at some point down the road that successfully monetizes the (now increased) value of the firm and provides significant returns for the principals and their co-investors. The global turmoil in credit markets during 2007e2009 triggered a collapse of private equity deals worldwide, which suggests that financial engineering rather than improved corporate governance tends to be the more important driver of the private equity industry. Both hedge funds and private equity firms work in tandem with commercial bank lending and securities markets to provide the leverage they need for their strategies to succeed, thus maintaining a symbiotic relationship with the financial system’s key financial intermediation channels. There are other connections with traditional financial intermediaries as well: some of the largest hedge funds are managed by investment banks, commercial banks and financial conglomerates, and the same is true of private equity investments, while at the same time several private equity firms provide advisory and other investment banking services to their clients. Finally, a broad spectrum of derivatives overlays the markets, allowing financial products to be tailored to the needs of end-users with increasing granularity, further expanding the availability and reducing the cost of financing on the one hand, and promoting the optimization of clients’ portfolios on the other. Interest-rate and currency swaps, for example, bridge both monetary units and fixed-income pricing conventions, making it possible to optimize the comparative financial market advantages of both borrowers and investors. Wherever there are market or credit risks, as well as other risks such as natural catastrophe or the weather, derivative contracts have emerged to efficiently transfer such risks to those best able to bear them, and this process has progressively covering the entire array of potential end-users, risk-tolerance and return objectives, both via exchange-traded and over-the-counter (OTC) contracts. Much of the innovation in derivatives (and thus much of the regulatory concern) has focused on such OTC contracts. As financial markets have developed, their end-users have been forced to become more performance-oriented in the presence of much greater pressures for transparency and competitiveness. It has become increasingly difficult to justify departures from highly disciplined financial behavior on the part of corporations, public authorities or institutional investors.
It has become increasingly difficult for corporations, public authorities or institutional investors to justify departing from highly disciplined financial behavior The financial crisis that began in 2007 has illustrated how easily financial innovation can go off the rails in terms of unintended consequences. Financial engineers designed highly profitable products that many e particularly asset managers and investors e failed to fully understand.2 Dodgy credits originated in one part of the world were packaged and repackaged and distributed to institutional and retail investors globally. Risk managers in the basements of financial intermediaries assured senior managers and directors that all was well, based on models incapable of capturing the real world. Managers of banks and other financial intermediaries who thought they were too big to fail ultimately wagered their entire institutions, with excessive leverage underwritten by debt holders who figured they would be bailed out by taxpayers if things went wrong. Each behavior made a lot of sense to those directly involved, but each potentially degraded the integrity of the financial system as a whole. When the system ultimately seized up, the damage extended far beyond those directly responsible. The risks in the system were aggregated, compounded and turbocharged, and innocent bystanders were caught in the maelstrom. Investors Long Range Planning, vol 42
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facing financial losses and needing liquidity found few buyers and sold whatever they could, causing all kinds of market turmoil, even in sectors far removed from the center of the crisis. The ensuing panic in the financial markets contaminated the broader economy, which in turn reinforced the financial turmoil itself, creating the worst global recession in over a quarter century. Meanwhile, wrong-footed policymakers desperate to stop the bleeding pushed healthier banks to acquire the mortally wounded, leading to still greater consolidation among financial intermediaries in a nightmare scenario of a small group of players that may yet prove to be too big, too interconnected, too conflicted, too complex, too hard to manage - and quite possibly too difficult to regulate. Is this the end of securitization, of derivatives, and financial innovation more broadly? Hardly. These are tools, and like any tool they can be misused e and in this case they have been in a massive way, by borrowers and issuers as well as by financial intermediaries and investors. But when the storm blows over, the more robust of these tools will reappear, many of them perhaps in altered form. Derivatives contracts will become more uniform and traded on organized exchanges or through central clearing houses. Rating agencies will adapt their assessments so that financial instruments that can’t be rated won’t be rated. Investors will do better due diligence and take a pass on assets they fail to understand. Financial institutions will have to refocus on efficiently providing price-sensitive commodity services, concentrating on the hard work of adding value for clients. All of this will come about because of a combination of regulatory change and market discipline, although skeptics may well wonder how fast market discipline will recede once memories of the crisis fade, and regulatory discipline has been undermined by politics.
skeptics may well wonder how fast market discipline will recede once memories of the crisis fade, and politics undermined regulatory discipline Consequences for institutional competitive advantage The basic microeconomics of financial intermediation results in institutional financial sector reconfiguration involving both in-sector and cross-sector reconfiguration in commercial banking (retail and wholesale), insurance (life and non-life), securities (retail and investment banking) and asset management (individual and institutional) as summarized in Figure 2. In retail financial services, extensive banking overcapacity in some countries has led to substantial consolidation. Excess retail production and distribution capacity has been slimmed-down in ways that usually releases redundant labor and capital, although in some cases this process has been retarded by large-scale involvement of public-sector institutions and cooperatives that operate under less rigorous financial discipline. Commercial retail banking activity has been linked strategically to retail brokerage, retail insurance (especially life insurance) and retail asset management through mutual funds, retirement products and private-client relationships. This linkage process has occurred selectively and sometimes involved simultaneous multi-links coupled to aggressive cross-selling efforts. At the same time, relatively small and focused firms have continued to prosper in each of the retail businesses, especially where they have been able to provide superior service or client proximity while taking advantage of outsourcing and strategic alliances. In wholesale financial services similar links have emerged. Wholesale commercial banking activities such as syndicated lending and project financing has often been shifted toward a greater investment banking focus, while investment banking firms have placed growing emphasis on developing institutional asset management businesses, partly to benefit from vertical integration and partly to gain some degree of stability in a notoriously volatile industry. These developments evolved further, and the 2007e2009 financial crisis saw the extinction of the independent broker-dealer as an organizational form with the bankruptcy of Lehman Brothers, the acquisition of Bear Stearns by JP 594
Economic Drivers of Structural Change in the Global Financial Services Industry
SECURITIES
Brokerage
Investment Banking
Retail
Wholesale
COMMERCIAL BANKING
ASSET MANAGEMENT
Retail & Private Clients
Life
Institutional
NonLife
INSURANCE
Figure 2. Multifunctional Financial Linkages
Morgan Chase and Merrill Lynch by Bank of America, and the conversion of both Morgan Stanley and Goldman Sachs into bank holding companies in order to gain access to government financing and guarantees. In some cases, large banks such as Bank of America, Barclays and Citigroup, have partially or wholly divested their asset management businesses due to the need to recapitalize themselves in the face of intense competition, high distribution costs or conflicts of interest with their investment banking activities. Meanwhile, other large banks such as JP Morgan Chase and Morgan Stanley have bulked up their asset management businesses to capitalize on expected future growth and reduced competition e alongside independent asset managers like BlackRock (the largest in the world in terms of assets under management). These crisis-related developments hardly spell the death knell for the independent broker-dealers, however, with new firms likely to emerge under post-crisis rules of the game and long-established firms like Goldman Sachs contemplating a return to some form of partnership structure. It seems clear that massive commercial banking organizations that have significant public-utility characteristics will in the future be restrained from running in-house ‘casinos’ (in terms of proprietary trading and investments) that can put the financial system in jeopardy, and so these risk-taking functions will have to migrate to other firms without such serious systemic attributes. Figure 3 provides an historical perspective, showing that, of the global volume of financial services restructuring between 1986 and 2007, roughly two-thirds occurred in the banking sector, one quarter in insurance and the remainder in asset management and investment banking. It seems clear that, from a structural perspective, a wide variety of financial services firms e commercial banks, savings banks, postal savings institutions, savings cooperatives, credit unions, securities firms (full-service firms and various kinds of specialists), mutual funds, insurance companies, hedge funds, private equity funds, finance companies, finance subsidiaries of industrial companies, and others - may perform one or more of the roles identified in Figure 1. Members of each strategic group compete with each other, as well as with members of other groups. Assuming it is allowed to do so, each organization elects to operate in one or more financial channels according to its own competitive advantages, and institutional evolution therefore depends on how these comparative advantages evolve, and whether regulation permits them to drive institutional structure. In some countries commercial banks, for example, have had to ‘go with the flow’ and develop competitive asset management, origination, advisory, trading and risk Long Range Planning, vol 42
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100% 90%
18% 25%
80%
28% 70%
25%
26%
24%
19% 17%
34%
60% 50% 40%
78% 68%
30%
59%
61%
63%
60%
66%
59%
44%
20% 10% 0%
1986-1988 1989-1991 1992-1994 1995-1997 1998-1999 2000-2001 2002-2003 2004-2005 2006-2007
Banking
Insurance
Investment Banking
Asset M anagement
Figure 3. Worldwide Financial Services Merger Volume, 1986e2007
management capabilities, under constant pressure from other banks and, most intensively, from other types of financial services firms. Industrial economics suggests that the structural form of competition between firms, within or between sectors, should follow the dictates of institutional comparative advantage. If there are significant economies of scale, or of scope, either with respect to costs or revenues (via cross-selling e selling multiple products to individual clients, such as retail banking and insurance in the form of bancassurance), or important linkages that can be exploited across geographies or client segments, we could expect to see the advantages reflected by, respectively, the size, the range of activities or the geographic scope or client breadth of those firms that are the most successful.
Products
A simple strategic schematic Figure 4 depicts the market for financial services as a matrix of clients, products and geographies. Financial firms will clearly want to allocate available financial, human and technological resources to those cells (market segments) in the matrix that promise to yield the highest risk-adjusted returns. In order to do this, they will have to attribute costs, returns and risks appropriately to
Client Segments
Figure 4. Product-Specific. Client-Specific and Geographic Strategic Linkages 596
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specific cells in the matrix, and the cells themselves must be linked together in a way that recognizes and maximizes what both analysts and practitioners commonly call ‘synergies.’ Client-driven linkages (vertical arrows) exist when a financial institution can, as a result of serving a particular client or client-group, supply financial services more efficiently either to the same or another client in the same group in the same or different geographies. Risk-mitigation results from spreading exposures across clients, along with greater earnings stability to the extent that income streams from different clients or client-segments are not perfectly correlated. Product-driven linkages (horizontal arrows) exist when a firm can supply a particular financial service in a more competitive manner because it is already selling the same or a similar financial service in other client or geographic dimensions. Here again, there is risk mitigation to the extent that net revenue streams from different products are not perfectly correlated. Geographic linkages (diagonal arrows) are important when an institution can service a particular client or supply a particular service more efficiently in a particular geography as a result of having an active relationship with that client, or presence with that service product, in another location. Once more, the risk profile of the firm may be improved where business is spread across different currencies, macroeconomic and interest-rate environments. To extract maximum returns from the market matrix, firms need to understand the size, growth and competitive dynamics of specific market segments, as well as the costs and the risks embedded in their overall portfolio of activities. Optimizing the linkages between the cells to maximize potential joint cost and revenue economies can be an especially challenging task, as discussed below: firms that do this well can be considered to have a high degree of ‘strategic integrity’ which should be reflected in a market capitalization that exceeds the stand-alone values of their constituent businesses.
Are larger firms associated with increased profitability and shareholder value? Does increased average firm size create a more efficient financial sector? The drivers of change Economies and diseconomies of scale The question as to whether economies or diseconomies of scale exist in financial services has been at the heart of strategic and regulatory discussions about optimum firm size in the industry. Are larger firms associated with increased scale economies and hence profitability and shareholder value?3 Does increased average firm size create a more efficient financial sector? Finding answers is not easy, as it demands isolating the pure impact of size of the production unit as a whole from all the other revenue and cost impacts of size, as discussed below. In an information- and transaction-intensive industry such as financial services, which often has high fixed costs, there should be ample potential for scale economies. However, the potential for diseconomies of scale attributable to disproportionate increases in administrative overheads, management of complexity, agency problems and other cost factors can also occur in very large financial services firms. If the economies prevail, increased size will help create financial efficiency and shareholder value: if the diseconomies prevail, both will be destroyed. Many studies of economies of scale have been undertaken in the banking, insurance and securities industries over the years,4 but unfortunately, examinations of both scale and scope economies in financial services are unusually problematic. The limited availability and conformity of data Long Range Planning, vol 42
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present serious empirical issues, and the conclusions of studies that have detected (or even failed to detect) economies of scale and/or scope in a sample of financial institutions do not necessarily have general applicability. Nevertheless, the impact on the operating economics of financial firms is so important that available empirical evidence is central to the whole argument.5 Cost estimation has uniformly found that economies of scale are achieved with increases in size among small commercial banks (below $100 million in asset size),6 while a few studies have shown that they may also exist in banks in the $100 million to $5 billion range.7 However, there is limited evidence to date of scale economies in the case of banks larger than $5 billion, and although there has been some recent scattered evidence of scale-related cost gains for banks up to $25 billion in asset size,8 there is none such for very large banks (exceeding $25 billion). Some studies have found the relationship between size and average costs to be U-shaped, suggesting that small banks can benefit from economies of scale as they grow bigger, but that large banks seem to suffer from diseconomies of scale and higher average costs due to factors like complexity as they increase in size. The inability of empirical research to find significant economies of scale among large financial services firms is also true of the larger insurance companies and broker-dealers. The consensus seems to be that scale economies and diseconomies do not generally result in more than about 8% difference in unit costs.9 In fact, except for the very smallest banks and nonbank financial firms, firm-wide scale economies seem likely to have relatively little bearing on competitive performance. For example, smaller institutions are sometimes linked together in cooperatives or other structures that allow them to harvest any available economies of scale centrally. An underlying research problem is that most available empirical studies focus entirely on firmwide scale economies, when the really important scale issues are encountered at the level of individual business units There is considerable evidence, for example, that economies of scale are significant for operational and competitive performance in areas such as global custody services, mass-market credit card transaction processing and institutional asset management, but they may be far less important in other areas, such as private banking and M&A advisory services. Unfortunately, empirical data on cost functions that would allow researchers to identify economies of scale at the product level are generally proprietary, and thus unavailable. Still, it seems reasonable to argue that a scale-driven strategy may make a great deal of sense in specific areas of financial activity, even in the absence of evidence that there is very much to be gained at the firm-wide level. However, observations of firm-wide economies of scale are elusive e and if the notion is that some lines of activity are likely to benefit from scale economies it must be equally likely that there are other lines that suffer from diseconomies of scale. Operating efficiencies Quite apart from the conventional economies of scale and scope just discussed, financial firms of roughly the same size and providing roughly the same range of services (i.e., where scale and scope are identical) can in fact have very different cost levels per unit of output. There is ample evidence that such performance differences exist, for example, in comparisons of cost-to-income ratios among banks, insurance companies and investment firms of comparable size. The reasons involve differences in production functions, reflecting efficiency and effectiveness in the use of labor and capital; sourcing and application of available technology; and acquisition of inputs, organizational design, compensation and incentive systems e i.e., in just plain better or worse management.
There is ample evidence that performance differences exist . in [the] cost-to-income ratios of comparable sized firms. [But, in the end,] the reasons involve .. just plain better or worse management. 598
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A number of studies have found that disparities in cost structures among banks of similar size can, in fact, be rather large, suggesting that the way banks are run is more important than their size or the selection of businesses they pursue. The consensus of studies conducted in the United States seems to be that average unit costs in the banking industry lie some 20% above those of ‘best practice’ firms producing the same range and volume of services, and that most of the difference can be attributed to operating economies rather than to differences in the cost of funds.10 If true, this is good news for smaller firms, as it suggest that the quality of management is far more important in driving costs than raw size or scope. Of course, if very large institutions are larger because they have been systematically better managed than smaller ones (which may be difficult to document in the real world of financial services) there may indeed be a link between firm size and operating efficiency. However, the performance of various different sized banks during the financial crisis of 2007e09 raises severe doubts about this proposition. It is also possible that very large organizations may be more capable of making the massive and ‘lumpy’ capital outlays required to install and maintain the most efficient information-technology and transactions-processing infrastructures. If such extremely high non-recurring technology spend-levels result in greater operating efficiency, large financial services firms will tend to benefit in competition with smaller ones e they will have to rely on pooling and outsourcing, where this is feasible. Cost economies of scope Beyond pure scale-effects, are there cost reductions to be achieved by selling a broader rather than narrower range of products? Cost economies of scope mean that the joint production of two or more products or services is accomplished more cheaply than producing them separately. ‘Global’ scope economies become evident on the cost side when the total cost of producing all products is less than that of producing them individually, while ‘activity-specific’ economies reflect the joint cheaper production of particular pairs or clusters of financial services. Such economies can be harvested through the sharing of IT platforms and other overheads, information and monitoring costs and the like. Information, for example, can be reused and thereby avoid cost duplication, facilitate creativity in developing solutions to client needs, and leverage client-specific knowledge. On the other hand, cost diseconomies of scope may arise from such factors as the inertia and lack of responsiveness and creativity that may come with increased firm breadth, complexity and bureaucratization, as well as ‘turf’ and profit-attribution conflicts that increase costs or erode product quality, or serious cultural differences between organizational ‘silos’ that inhibit seamless delivery of a broad range of financial services. Like economies of scale, cost-related scope economies should be directly observable in costs of financial services suppliers and in aggregate performance measures. But empirical studies have generally failed to find significant cost-economies of scope in the banking, insurance or securities industries,11 though they do suggest that some cost-diseconomies of scope are encountered when firms in the financial services sector add new product-ranges to their portfolios - in fact, as product ranges widen, unit-costs seem to go up (although not dramatically). However, given the period covered by many of these studies, they tend to involve firms that were shifting away from a pure focus on banking or insurance, and that may therefore have incurred considerable front-end costs in expanding their activity range. Assuming these outlays affected firms’ accounting statements during the study period, one might expect to see this evidence of diseconomies of scope reversed in future periods. Revenue economies of scope On the revenue side, economies of scope attributable to cross-selling arise when the all-in cost of buying multiple financial services from a single supplier is less than that of purchasing them from separate suppliers. This includes the cost of the services themselves plus information, search, monitoring, contracting and other costs. And firms that have diversified into several types of activities or geographic areas will also tend to be make life easier for their clients by offering them more contact points. (As with the cost side, revenue diseconomies of scope could also arise from the management complexities and conflicts associated with greater breadth.12) Long Range Planning, vol 42
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Historical studies have yielded some evidence on revenue economies of scope. Some studies have found that U.S. bank affiliates typically underwrote better performing securities than specialized investment banks during the 1920s, when US commercial banks were permitted to have securities affiliates. Perhaps commercial banks obtained knowledge about firms contemplating selling securities through the deposit and borrowing history of the firm, which would enable them to select the best risks to bring to market.13 Other research has found that securities underwritten by commercial banks generated higher prices than similar securities underwritten by investment banks, which suggests the former carry lower ex ante risks. Most empirical studies of cross-selling are based on survey data, and are difficult to generalize.14 Regarding wholesale commercial and investment banking services, for example, one issue is whether different services are separable e with companies going to firms with the perceived best relevant capabilities (probably investment banking houses) for M&A advice and to others (presumably major commercial banks) for loans - or whether they are more likely to award M&A work to banks that are also willing lenders. This is sometimes called ‘mixed bundling,’ meaning that the price of one service (e.g., commercial lending) is dependent on the client also taking another service (e.g., M&A advice or securities underwriting). The search for immediate scope-driven revenue gains can be argued to have led to some disastrous lending by commercial banks in the energy and telecoms sectors in recent years.15 However, it is at the retail level that most revenue economies of scope are likely to materialize, since the search and contracting costs of retail customers are likely to be higher than those of corporate customers. The regulatory restraints in place until 1999 mean that there is only limited US evidence on retail cross-selling, and evidence from Europe (where universal banking has always been part of the landscape) is mainly case-based and suggests highly variable outcomes as to the efficacy of bancassurance or Allfinanz.
[future] business models, with clients using software interfaces to access multiple financial services vendors .. ‘cross-purchasing’ rather than ‘cross-selling’ . [may make] the rationale for revenue economies of scope obsolete. In any case, the future may see some very different retail business models, with clients taking advantage of user-friendly software interfaces to access Webservice platforms which allow realtime linkages to multiple financial services vendors. In effect, this will amount to ‘cross-purchasing’ rather than ‘cross-selling’, and promises to give the client a combination of the ‘feel’ of singlesource purchasing along with access to best-in-class vendors. Apart from the continuous need for financial advice, such a business model could reduce information, transaction and contracting costs, while at the same time providing client-driven open-architecture access to the universe of competing vendors. Advice could be built into the model, either by suppliers incorporating an advisory function into their downlinks, or from independent financial advisers. If such models of retail financial services delivery take hold in the market in the future, some of the rationale for cross-selling and revenue economies of scope could become obsolete. Despite an almost total lack of hard empirical evidence, revenue economies of scope may indeed exist at both the wholesale and retail level, but they are likely to be very specific to the types of services provided and the types of clients served. So revenue-related scope economies are clearly linked to a firm’s specific strategic positioning across clients, products and geographies (as depicted in Figure 4). What little empirical evidence there is suggests that revenue-economies of scope seem 600
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to exist for specific combinations of products in the realms of commercial and investment banking, as well as insurance and asset management,16 but the proprietary nature of relevant in-company data has meant no empirical studies have so far been available to confirm or refute the existence of revenue economies of scale at the individual product level. Even if the potential for cross-selling exists, the devil is in the detail e mainly in the design of incentives and organizational structures to ensure that it actually occurs. These incentives have to be extremely granular and compatible with real-world employee behavior, or no amount of management pressure and exhortation to cross-sell is likely to succeed. In general, it seems likely that (given imperfect information) the broader a financial firm’s activity-range, (1) the higher will be the potential agency costs facing clients, (2) the greater will be the probability that it will encounter potential conflicts of interest, and (3) the more difficult and costly will be the internal and external safeguards necessary to prevent the exploitation of such conflicts of interest. If this is so, the competitive consequences associated with conflict-exploitation could offset the realization of economies of scope in financial services firms. The adverse legal, regulatory and reputational consequences of exploitating such conflicts e along with the managerial and operational costs of complexity e can be considered likely to point to the presence, rather, of diseconomies of scope.17 Market concentration and leadership In addition to the strategic search for operating economies and revenue synergies, financial services firms will also seek to dominate markets in order to extract superior economic returns. This is often referred to as yielding economies of ‘size’, as opposed to classic economies of ‘scale,’ and can convey distinct competitive advantages that are reflected in either business volume or margins, or both. Many national markets for financial services have shown a distinct tendency towards oligopoly, with market power allowing banks to charge more (monopoly benefits) or pay less (monopsony benefits). Supporters of this state argue that high levels of market concentration are necessary in order to provide a viable competitive platform, while opponents argue that, without convincing evidence of scale economies or other size-related efficiency gains, monopolistic market structures serve mainly to extract rents from consumers or financial services users, and redistribute them to shareholders, or to cross-subsidize other areas of activity, invest in wasteful projects or reduce pressures for cost-containment.
managers believe in an industry end-game [of] a few firms in gentlemanly competition with nice sustainable margins . in reality [this can] trigger public policy reaction to restore vigorous competition Indeed, it is a puzzle why managers of financial services firms often seem to believe that the endgame in their industry’s competitive structure is the emergence of a few firms in gentlemanly competition with nice sustainable margins, whereas in the real world such an outcome can easily trigger public policy reaction leading to breaks-ups and spin-offs in order to restore more vigorous competition. Particularly in a critical e and thus highly politicized e economic sector such as financial services, a regulatory response to ‘excessive’ concentration is a virtual certainty, despite the (often furious) lobbying. In Canada, for example, regulators blocked two mega-mergers in late 1998 that would have reduced the number of major financial firms from five to three, with a retail market share of perhaps 90% between them, despite management arguments that major US financial services firms operating in Canada under North American Free Trade Agreement (NAFTA) rules would have provided the necessary competitive pressure to prevent the exploitation of monopoly power. Long Range Planning, vol 42
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Despite very substantial consolidation in recent years within perhaps the most concentrated financial services industry segment - wholesale banking and capital markets activities - there is little evidence of monopoly power. Although some 80% of the combined value of global fixed-income and equity underwriting, loan syndications and M&A mandates is captured by the top-ten firms, the industry remains subject to ruthless competition in most of these business areas. This competition has been reflected in the declining returns to investors with shares in the principal industry players - in fact, despite all the consolidation activity, there has been a long-term erosion of returns on capital invested in the wholesale banking industry. A similar situation exists in asset management, where the top firms comprise a mixture of European, American and Japanese asset managers, plus a variety of banks, broker-dealers, independent fund management companies and insurance companies. Although market definitions clearly have to be drawn more precisely, at least on a global level asset management seems to be among the most contested sectors in the entire industry, despite having shown some signs of increasing concentration in recent years.18 In short, although monopoly power created through mergers and acquisitions in the financial services industry can produce market conditions that allow firms to reallocate gains from clients to themselves, such conditions are not easy to achieve or to sustain. New players e even relatively small entrants e can penetrate the market and destroy oligopolistic pricing structures, and consumers are willing to shop around among good substitutes available from other types of financial services firms. Even after intensive M&A activity, vigorous competition seems to have been maintained in most cases, as a consequence of the relatively even distributions of market shares among the leading firms in many financial services sectors.
monopoly power allows firms to reallocate gains from clients to themselves, [but is] not easy to achieve or to sustain . small entrants can easily destroy oligopolistic pricing and consumers shop around Proprietary information and imbedded human capital One argument in favor of large, diverse financial services firms is that internal information flows are substantially better - and involve lower costs - than the external information flows available to more narrowly focused firms. Consequently a firm that is present in a broad range of financial markets, functions and geographies can find proprietary and client-driven trading and structuring opportunities that smaller and narrower firms cannot. A second argument has to do with technical know-how. Significant areas of financial services e particularly wholesale banking and asset management e have become the realm of highly specialized expertise, which can be reflected in both market share and price effects. In recent years, large numbers of financial ‘boutiques’ have been acquired by major banks, insurance companies, securities firms and asset managers for precisely this purpose, and anecdotal evidence suggests that in many cases these acquisitions have been shareholder-value enhancing for the buyer. Closely aligned to this is the human capital argument. Technical skills and entrepreneurial behavior are embodied in people, and people can (and do) move between firms. Parts of the financial services industry have become notorious for this mobility of talent, sometimes to the point of ‘freeagency,’ with people or even teams of people seemingly regarding themselves as ‘firms within firms.’ There are no empirical studies of these issues, although there is no question as to their importance. Many financial services are specialist businesses, conducted by specialists, to meet specialist client requirements. The know-how embodied in people is clearly mobile, and the key is to provide a platform that is sufficiently incentive compatible to make the most of it. But in terms of the wider arguments, it is unclear whether size or breadth has much to do with this. 602
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Significant areas of financial services have become highly specialized . skilled and entrepreneurial people can (and do) move between firms. . [but] it is unclear if size or breadth have much effect.. Diversification, financial stability and too-big-to-fail guarantees Greater diversification of earnings attributable to multiple products, client-groups and geographies is often deemed to create more stable, safer, and ultimately more valuable financial institutions. The lower the correlations among the cash flows from the firm’s various activities, the greater the benefits of diversification. The consequences should include higher credit quality and higher debt ratings (due to lower bankruptcy risk), and therefore lower costs of financing than those faced by narrower, more focused firms, while greater earnings stability should bolster stock prices. In combination, these effects should reduce the cost of capital and enhance profitability.19 Given the unacceptable systemic consequences of institutional collapse, large financial services firms that surpass a given threshold will usually be bailed-out by taxpayers, as the 2007e09 financial crisis clearly demonstrated. This policy became explicit in 1984 in the United States when the Comptroller of the Currency testified to Congress that 11 banks were so important that they would not be permitted to fail, and bailouts were clearly present in the savings and loan collapses around that time. The same policy tends to exist in other countries, and seems to cover even more of the local financial system: there were numerous examples in France, Switzerland, Norway, Sweden, Finland and Japan during the1990s. Too-big-to-fail (TBTF) guarantees, whether explicit or implicit, create a potentially important public subsidy for major financial firms. TBTF support was arguably extended to non-bank financial firms in the rescue of Long-term Capital Management, Inc. in 1998, brokered by the Federal Reserve (despite the fact that a credible private restructuring offer was on the table) on the basis that the firm’s failure could cause systemic damage to the global financial system. The same argument was made by JP Morgan in 1996 about the global copper market and one of its then-dominant traders, Sumitomo, when they suggested that collapse of the copper market could have serious systemic effects. The speed with which the central banks and regulatory authorities reacted to that crisis signaled the possibility of safetynet support of the copper market in the light of major banks’ massive exposures in highly complex structured credits to the industry. And there were even mutterings of systemic effects in the collapse of Enron in 2001, WorldCom in 2002. Most of the time such arguments are self-serving nonsense, but in a political environment under crisis conditions, TBTF guarantees could help throw a safety net broad enough to limit damage to shareholders of exposed banks or other financial firms. It is generally accepted that the larger the bank, the more likely it is to be covered under TBTF support. The same is true of a smaller bank that is so interconnected with the global network of financial flows that its failure could bring down the whole network. Without state assurances, uninsured depositors and other liability holders demand a risk premium, but for a bank that will not be allowed to fail, this premium is no longer necessary. And, of course, there is the problem of moral hazard, as this policy can be thought of as giving large and interconnected banks the incentive to increase the risk of their operations in the chase for higher equity returns.
under crisis conditions, too-big-too-fail guarantees throw a broad safety net limiting damage to shareholders . [but] may [encourage] firms in riskier operations to chase higher returns. Long Range Planning, vol 42
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Conglomerate discount It is often argued that, all else being equal, the shares of multi-product firms and business conglomerates tend to trade at prices lower than shares of more narrowly-focused firms. There are two basic reasons why this ‘conglomerate discount’ is alleged to exist.20 First, it is argued that, on the whole, conglomerates tend to use capital inefficiently. This may be attributable to managerial discretion to engage in value-reducing projects, cross-subsidization of marginal or loss-making projects that drain resources from healthy businesses, misalignments in incentives between central and divisional managers, etc. Most erosion of value in conglomerates is usually blamed on over-investment in marginally profitable activities and cross-subsidization. If it is true that conglomerates’ internal capital markets function less efficiently than the external capital market, their shares ought to trade at a discount to the stand-alone value of their constituent businesses.21 The empirical findings from research across broad ranges of nonfinancial businesses may well also apply to the diverse activities carried out by financial firms. If retail and wholesale banking, and P&C insurance, are evolving into highly-specialized, performance-driven businesses, for example, one may ask whether the kinds of conglomerate discounts found in industrial firms may not also apply to financial conglomerate structures - especially if centralized decision-making is becoming increasingly irrelevant to the requirements of the specific businesses.22 A second possible source of a conglomerate discount is that investors in shares of conglomerates find it difficult to ‘take a view’ and will want to avoid such stocks, preferring to add pure sectoral exposures in their efforts to construct efficient asset-allocation profiles. This is especially true where performance-driven managers of institutional equity portfolios are under pressure to outperform cohorts or equity indexes e why would such a fund manager want to invest in yet another (closed-end) fund in the form of a conglomerate, which might be active in retail and wholesale commercial banking, in middle-market lending, private banking, corporate finance, trading, investment banking, asset management insurance and perhaps other businesses as well? Both the capital-misallocation and the portfolio-selection effects tend to weaken investors’ demand for shares of universal banks and financial conglomerates, thus lowering their equity prices and leading to a higher cost of capital. In turn, this will have a bearing on the competitive performance and profitability of the enterprise, which may be enough to wholly or partially offset some of the aforementioned benefits of conglomeration, such as greater stability and lower bankruptcy risk through diversification across business lines. Recent large-scale empirical studies have attempted to ascertain whether or not functional diversification in the financial services sector is value-enhancing or value-destroying. One such study, based on a large U.S. dataset covering the period 1985e2004,23 found evidence of substantial and persistent conglomerate discounts among financial intermediaries, with the empirical results suggesting that it was diversification that caused the discounts, rather than them resulting from troubled firms diversifying into other more promising areas.24 The study also investigated both the geographic dimension of diversification and the interaction between geographic scope and functional diversification, concluding that the value-destruction associated with functional diversification was not apparent with geographic diversification. It also found a significant valuation premium for the very largest of its sample firms (those with total assets above $100 billion) indicating the worth of TBTF guarantees for very large financial conglomerates. These results were broadly in line with those of another study that found strong evidence of a conglomerate discount in a sample of 836 banks from 43 different countries.25
This shift of financial flows from regulated depository institutions to the free, open, global financial marketplace has led to efficiency and innovation [but] at the cost of an [unforeseen] level of fragility. 604
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Financial turbulence and structural change in global banking The financial global crisis that began in 2007, and has continued into 2009, has raised numerous questions as to whether the economics of global financial intermediation would fundamentally change as a result, or whether the crisis was an adjustment to excessive leverage and risk-taking among wholesale commercial and investment banks and their investor clients. Equally, the massive injection of liquidity into financial markets by the Federal Reserve (including central bank credit extended to nonbanks), the Bank of England and other central banks, together with bailouts of Northern Rock, IndyMac, Bear Stearns, Fannie Mae and Freddie Mac, seems to make it a virtual certainty that regulatory changes would follow, which would profoundly change the way global wholesale banking operates. As noted above, such financial sector bailouts trigger moral hazard and, since their ultimate cost is always carried by taxpayers, they inevitably bring with them expectations of tighter regulation. The Fed-brokered acquisition by JP Morgan Chase of Bear Stearns and its assumption of $29 billion in assets of questionable value, along with its action in opening its discount window to non-bank as well as bank borrowing secured by potentially tainted collateral (offering ‘cash for trash’) made it apparent that in the future governments are likely to participate in bailing-out individual financial intermediaries whose collapse is thought to pose a danger to the financial system, whether or not they are banks - not to mention the slippery slope toward bailing out systemically-important nonfinancial companies in sectors such as automotive, steel, agribusiness and the like. This process cannot but expose taxpayers to further significant losses.
financial sector bailouts trigger moral hazard and, since their ultimate cost is always carried by taxpayers, inevitably bring expectations of tighter regulation. Unlike previous periods when bailouts have been contemplated, or occurred, the 2007e09 crisis came from a massive loss of confidence in the surge of collateralized mortgage obligations and other structured financial instruments which have been created in recent years e as discussed above in the context of financial innovation. These have often been highly complex bonds, collateralized by bundled mortgages known to contain some amount of risky, sub-prime obligations likely to be worth less than their face value. Since investors don’t know for sure that they are immune to such losses, the rational thing to do is to run e flooding the market with sellers and robbing it of buyers e despite the fact that in the end default rates might not in fact by large enough to significantly impact the bulk of the outstanding debt obligations. The result was an extended liquidity panic, one that focused on the global capital markets e markets that are ostensibly not guaranteed by the government e rather than on the balance sheets of insured and regulated banks and mortgage lending institutions. This shift of financial flows from regulated depository institutions to the free, open and global financial marketplace has been one of the most positive developments in finance of the last twenty years. It led to more competition, more efficient asset pricing, more granular risk allocation, more transparency in most financial markets and lower cost of capital. In 2008 the market capitalization of all the world’s stocks and bonds exceeded $100 trillion, several times the combined amount of all the world’s bank deposits. Along with the efficiency and innovation, however, it can now be seen that these ‘gains’ have come at the cost of a degree of fragility that few market participants e or outside observers e recognized while the new edifice was being constructed.26 One source of this fragility has been the heavy concentration in global financial intermediation. The principal market intermediaries e those who created, packaged and distributed securitized Long Range Planning, vol 42
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mortgage loans and many other structured investment vehicles e are only two dozen or so publiclytraded financial service giants that had positioned themselves at the center of global financial flows where, collectively, they have dominated transactions. These financial colossi underwrote, distributed and traded securities of all types, as well as simultaneously managing families of funds including in-house hedge funds and private equity portfolios, and often serving as principal investors, prime brokers and M&A advisers. They generated transactions imaginatively and aggressively, with the objective of selling their holdings to others as quickly as possible, pocketing both fees and trading profits. Theirs was a highly competitive, mark-to-market business e whereby assets are carried on the books at current market values rather than book values e which is especially problematic when no credible market for those assets exists. It was also a risky one, and extremely prone to herd-like behavior. In a business totally founded on confidence, its erosion almost always starts a death-spiral: when things go wrong, all are affected at the same time and in the same direction because all are involved in the same markets. Losses and write-offs are inevitable, the share prices of the financial giants collapse, and market liquidity seizes-up for a time, threatening real harm to the real economy.
Many of those who created the financial mess have taken large rewards off the table, leading to a widespread perception of ‘privatization of gains and socialization of risks.’ This happened in 1990 after the collapse of the junk-bond and LBO markets, in 1998 after the Russian debt default and the collapse of Long Term Capital Management, and in 2000 after the dot-com bubble, and when it happened again in 2007e09 it created enormous losses for the shareholders of major banks and broker-dealers (see Table 1). Many of those involved in creating the financial mess had taken large financial rewards off the table, leading to a widespread perception of ‘privatization of gains and socialization of risks.’ Since this situation was politically unsustainable, it was inevitable that there would be calls for structural remedies, such as a modern version of the 1930’s era US separation of commercial and investment banking. After all, it has been widely noted that every major American credit institution e backed by deposit insurance and access to ‘too big to fail’ support e has been caught in the biggest financial crisis since Great Depression of the 1930s, less than a decade after the 1999 repeal of the Glass-Steagall provisions of the 1933 US Banking Act. The likely form of regulation But as long as financial intermediaries (whether they are banks, broker-dealers, hedge funds or major asset managers) are considered too big, too complex or too interconnected to be allowed to fail, they are likely to be supported at public expense, either through support of their liabilities or of their assets. And it is the general public that will pay, either through public expenditures, derailed monetary policy and higher inflation that favors debtors, or in bearing levels of risk for which they are not being compensated. Experience during the crisis in the US, the UK and continental Europe has shown that the key intermediaries (even mid-size broker-dealers) are so integral to the functioning of the global financial system that they, too, have to be saved from failure, constituting a contingent liability that the government and taxpayers have implicitly assumed in the interests of banking and financial market stability. This has resulted in an acute form of moral hazard, in which the gains from successful short-term risk-taking have been allocated in large measure to the employees of the firms involved, but where a significant extent of the losses (even after the collapse of financial share-prices and firm recapitalizations) will have to be absorbed by the general 606
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Table 1. Top-50 Write-downs 1 January 2007 to 15 July 2009 (billions of US dollars)
Firmz
Loss
Capital
Wachovia Corporation Citigroup Inc. Bank of America Corp. Merrill Lynch & Co UBS AG HSBC Holdings Plc Washington Mutual Inc. JPMorgan Chase & Co Royal Bank of Scotland Wells Fargo & Company HBOS Plc National City Corp. Barclays Plc Morgan Stanley Credit Suisse Group AG Deutsche Bank AG BNP Paribas Bayerische Landesbank Lehman Brothers Holdings ING Groep N.V. IKB Deutsche Industries PNC Financial Service Societe Generale KBC Groep NV Banco Santander SA Fortis Canadian Imperial Bank Goldman Sachs Group Natixis Credit Agricole S.A. Mizuho Financial Group DZ Bank AG SunTrust Banks Inc Other European Banks Hypo Real Estate Holdings Dexia SA Fifth Third Bancorp UniCredit SpA U.S. Bancorp Other Asian Banks Bank of China Ltd E*Trade Financial Corp. Indymac Bancorp Dresdner Bank AG Commerzbank AG Royal Bank of Canada Landesbank Baden-Wuerttemberg Nomura Holdings Inc. HSH Nordbank AG Mitsubishi UFJ Financial
101.9 112.2 69.6 55.9 53.1 50.1 45.3 49.2 32.8 32.8 30.2 25.2 24.2 23.0 19.4 18.9 17.2 17.1 16.2 16.4 14.8 12.4 12.3 12.1 11.1 9.4 9.1 9.1 9.0 8.9 8.6 7.8 7.8 7.6 7.1 6.8 6.6 6.4 6.2 6.0 5.9 5.4 5.2 5.2 5.6 5.7 4.7 4.2 4.2 4.2
11.0y 109.4G 99.3 29.9y 38.5 29.4 12.1y 49.7 57.0G 50.4 26.3y 8.9y 31.3 28.8C 12.5 6.1 7.4 21.3 13.9y 20.9 12.2y 8.7 14.3 7.9 20.5 23.1y 2.9 28.2C 8.2 12.8 10 0.0 6.3 4.9 0.1y 9.2y 7.0 9.0 9.1 20.4 5.9 2.6 0.0y 0.0 26.2 2.5 0.0 8.7 1.8 21.7
G, Government control. C, Converted to bank holding company. Summary: Total estimated write-downs - $4 trillion; Taken by banks: $ 2.7 billion; Losses US e 50% Europe e 44% Rest of world e 6%. y
Terminated.
public. But socializing risk gives the public the right to control those benefitting from public support, and (as widely assumed) greater regulation is certain to come. It may be that the massive shareholder losses seen among financial institutions will lead to better corporate governance among financial firms, and in turn a better balance between risks and rewards e a selfcorrection that would serve the interests of the shareholder and the taxpayer alike. However, in the hyper-competitive financial market that will doubtless soon reappear, market discipline is unlikely to be sufficient, and in any case will dissipate in plenty of time for the next crisis. To be effective, regulatory pressure will have to focus on the interrelated issues of solvency (of institutions) and liquidity (of both institutions and instruments). For bank-based firms the issue of solvency has already been addressed in the Basel 2 banking reforms, but will have to be revisited in the light of ensuing events, including strengthening incentives to recognize the underlying sources of risk and how it is modeled, and reviewing the treatment of key securitization exposures and off balance sheet commitments. The business models of those financial intermediaries that rely on extreme leverage are likely to change dramatically. In availing themselves of public-sector support, they will inevitably be drawn into whatever regulatory net finally emerges. They will also be subject to regulation designed to combat borrower fraud and force improved due diligence on the part of debt originators and wholesale financial intermediaries. All wholesale financial intermediaries will be under pressure to review whether the structure and effectiveness of their operations’ risk management are commensurate with the risks they run in their business models. In the matter of liquidity of financial instruments, there will be a great deal of discussion about transparency in the structure of financial instruments, and suggestions of common templates for securities design, disclosure and approaches to valuation e possibly leading to significant migration of over-the-counter transaction towards organized exchanges, eliminating counterparty risk in the process, but also sacrificing some degree of innovation, as well as substantial sources of earnings for wholesale intermediaries. This includes the market for credit derivatives, which has undoubtedly improved granularity in risk allocation in recent years, but which has encountered major problems in transparency and counterparty exposures of its own, and has arguably promoted herd-like behavior in times of severe credit stress.
regulatory change [aims] to improve financial system stability with minimum losses in efficiency [but it] involves balancing the unmeasurable against the unknowable. As always, the objective of regulatory change is to improve the stability of the financial system with minimum losses in efficiency. Since measurement of the latter is highly problematic e and as instability shows up only after it’s too late - the issue involves balancing the unmeasurable against the unknowable e and will at different times unavoidably involve either over- or under-regulation. In the process, the remaining full-service investment banks may well be fundamentally transformed, disappearing into commercial bank-based financial conglomerates or fundamentally transforming their business models. But since (as discussed earlier) financial conglomerates usually trade at a discount from their sum-of-parts valuations, further consolidation could represent a further loss of value to the global financial industry. Systemic risk and the ‘polluter pays’ principle Since the onset of the 2007e09 financial crisis, discussions of global banking and finance have been almost entirely about systemic risk and its consequences.27 Confronting the key causes of systemic risk head-on will be at the core of any effort to create a more robust global financial system. 608
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Borrowing from a very different field, it may be that the successful evolution of policy on pollution and the natural environment over the past half-century carries some very useful lessons for how to proceed. Environmental damage usually involves a market failure that neglects to price a key resource, the natural environment. People and businesses produce or consume in ways that make sense for themselves, but in doing so cause pollution and damage to others. Toxic effluent damages users of water resources, smokestack emissions harm downwind residents, solid-waste dumps contaminate groundwater and despoil the local terrain, and so on. Once society gets serious about pollution, it sets out either to control the physical activities that cause pollution, or to impose charges that encourage polluters to clean up their act. The best solution is usually found in a simple rule e the ‘polluter pays principle’ e because it uses market forces to correct the problem in the most efficient possible way. Society uses the political and regulatory process to set environmental standards and policies to enforce them, and polluters themselves figure out the best way to meet those standards. The external environmental costs are forced back onto the polluter, who in turn deals with them and passes any costs on to customers, in the form of higher prices, or back to shareholders, in the form of lower returns. Either way, the ‘magic of the market’ reinforces environmental policy: the more polluting a product or service, the more expensive it will be to buy, or the less profitable it will be to produce. The market economy helps to achieve society’s environmental targets in the most efficient way by properly allocating scarce environmental resources, all the while making clear that there is no free lunch e the fact is somebody has to pay for a cleaner environment.
systemic financial market failure essentially creates ‘financial pollution’ [as] the pursuit of private gain imposes serious costs on the whole system . a financial equivalent of the ‘Polluter Pays’ principle is needed. Market failure in global finance isn’t all that different: systemic institutional failure essentially creates ‘financial pollution’, with firms and individuals in the pursuit of private gain imposing serious costs on the financial system as a whole. The key problem is to recognize, measure and price the systemic risk created by private financial activities, and force those who create it to pay for insuring it. The way to do this is a financial version of the polluter pays principle. First, government deposit insurance and too-big-to-fail guarantees of financial institutions need to be repriced, commensurately increasing the costs to those who directly benefit from deposit guarantees e the banks and their depositors; Second, capital adequacy needs to be redefined in a world that will inevitably still have numerous financial ‘casinos’ engaged in risk-taking and speculation, likewise raising the financial cost of taking risks to those firms who elect to participate, who will then have to choose to pass it along to shareholders or to customers; Third, liquidity individual institutions must be adequate and aligned to their business functions and market conditions, even at the cost of significant profit opportunities foregone as a result of larger liquid asset holdings; Fourth, the structural complexity and interconnectedness of financial intermediaries themselves call for a special systemic surcharge, in order to recognize that some internal transfers of risk are not captured by conventional regulatory oversight.
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However it’s done, any new regulations imposed on banks and other financial intermediaries must impose serious costs on shareholders of the firms and their clients in order to price systemic risk correctly. Chances are, they will respond in line with their self-interest to seek the most costefficient ways to comply. Again, we will see the market work its proverbial magic: financial products and institutions imposing high levels of risk on the financial system will rise in price and fall in profitability relative to others, and financial flows will better incorporate the systemic risks involved. The generators of systemic risk will pay, and this will feed through the system e new rules based on proper pricing of systemic risk will help restore the financial system at the lowest possible cost in terms of both efficiency and growth.
the market will work its proverbial magic: products and institutions imposing high levels of risk will rise in price and fall in profitability
Conclusions Strategic initiatives in financial firms increase shareholder value if they generate: Top-line gains which show up as market-extension, increased market share, wider profit margins or successful cross-selling; Bottom-line gains related to lower costs due to economies of scale or improved operating efficiencies, usually reflected in improved cost-to-income ratios, as well as better tax efficiency; or Reductions in risk associated with improved risk management or diversification of the firm across business streams, client segments or geographies whose revenue contributions are imperfectly correlated. But assessing the potential effects of size and scope in financial services firms is as straightforward to understand in concept as it is difficult to calibrate in practice. The positives include economies of scale, improvements in operating efficiency (including the impact of technology), cost economies of scope, revenue economies of scope, impact on market structure and pricing power, improved financial stability through diversification of revenue streams, improvements in the attraction and retention of human capital, and possibly TBTF support. The negatives include diseconomies of scale, higher operating costs due to increased size and complexity, diseconomies of scope on either the cost or revenue sides (or both), the impact of possible conflicts of interest on the franchise value of the firm, and a possible conglomerate discount in the share price. Bigger and broader is sometimes better, sometimes not: it all depends. The evidence so far suggests rather limited prospects for firm-wide cost economies of scale and scope among major financial services firms in terms of overall cost structures, although they certainly exist in specific lines of activity. Operating economies seem to be the principal determinant of the cost levels differences observed among banks and nonbank financial institutions. Revenueeconomies of scope through cross-selling may well exist, but, again, they are likely to apply very differently to specific client segments and product lines. Conflicts of interest can pose major risks for shareholders of multifunctional financial firms, which may materialize in civil or even criminal litigation and losses in franchise value. While there is plenty of evidence that diversification across uncorrelated business streams promotes stability, unexpected correlation ‘spikes’ (as between insurance and investment banking) may arise from time to time, and there is the specter of conglomerate discount that must be confronted. Table 2 shows one way to profile the financial services firms that are likely to characterize the post-crisis global financial environment. It is still a rich mosaic of contestability, with individual 610
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Table 2. One way to segment the global players
Types
Examples
Global ‘‘Megabanks’’ Boutiques Wholesale Universals Insurance Bancassurance Commercial Banks + Specialists Private Banks Asset Managers
Citigroup, HSBC, Bank of America Blackstone, Evercore, Greenhill & Co, Lazard Fre`res UBS, Deutsche Bank, Credit Suisse,Goldman Sachs, Morgan Stanley Allianz, Swiss Re, AIG (nationalized), AXA, Prudential, Dai-ichi Mutual ING Unicredit, Santander, BBVA ,Wells Fargo, Commerzbank State Street, BONY/Mellon, Charles Schwab Julius Baer, LODH, Pictet, Rothschild Vanguard, Fidelity, BlackRock, Capital Group
cohorts of firms competing against each other and against firms in other cohorts. This institutional pattern is likely to persist for the foreseeable future. Two additional observations can be made. First, the largest firms are not necessarily the most valuable, and the lists are highly diverse: both generalists and specialists co-inhabit the top of the global financial services league tables. Both observations suggest that the key is in ‘how’ things are done rather than ‘what’ is done, and that quality of management offers greater promise of success than size. Second, the absence of clear signs of ‘strategic dominance’ e generalists gaining the upper hand over specialists or the other way round e is encouraging. Any number can play, and there are no magic formulas. The devil remains in the detail - so once again, there is a premium on plain old good management This diversity in the financial system is probably a good thing from a systemic perspective as well, as the competition between firms both within and across strategic groups will continue to put a premium on both efficiency in financial allocation and innovation in the evolution of financial products and processes.
a rich mosaic of individual firms still compete against each other . generalists and specialists co-inhabit the top of global financial services tables. There are no magic formulas - ‘how’ things are done remains more important than ‘what’ is done. Larger is not necessarily more valuable . plain old good quality management [still] offers greater promise of success
Acknowledgements The author is grateful to Anthony Saunders and Roy Smith for helpful comments on earlier drafts of this article and to the editors and anonymous referees of this special issue.
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Biography Ingo Walter is the Seymour Milstein Professor of Finance, Corporate Governance and Ethics at the Stern School of Business, New York University, and Vice Dean of Faculty. He has taught at New York University since 1970. He serves as a consultant to various corporations, banks, government agencies and international institutions and has authored or co-authored numerous books and articles in the fields of international trade policy, international banking, environmental economics, and economics of multinational corporate operations. Among his recent publications are Governing the Modern Corporation (New York: Oxford University Press, 2006) and Can Microfinance Reduce Portfolio Volatility? Economic Development and Cultural Change, October 2009. Stern School of Business, New York University, 44 West 4th Street, New York, NY USA. Tel: +1 212 997 0707, Fax: +1 212 995 4212, e-mail:
[email protected].
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