The Future of Financial Services By Roy C. Smith NYU Stern School of Business “Financial Services” is a term that covers a lot of ground – banking, investment banking, mutual funds, hedge funds, foreign exchange, commodities and more. It’s a vast industry -- the market capitalization of all stocks, bonds and derivatives in the world at the end of 2009, for example, was more than $160 trillion, most of which was traded outside the United States. In addition there were $95 trillion of assets held by banks. Together they added up to $255 trillion of financial assets. These involved annual turnover well in excess of $100 trillion, plus another $3 trillion per day of foreign exchange transactions. Financial services businesses essentially break down into two components --wholesale and retail. The wholesale market includes securities, loans, and derivatives, which are sold to sophisticated financial institutions and high net worth investors. Retail services include a variety of credit and brokerage products sold to individuals. Most countries apply strict regulation to retail financial services and products, and (until recently) much less strict control of wholesale market products. Market Forces and Weak Regulation For two generations, financial services have been caught in the grip of three powerful forces – globalization, deregulation and technology – that have significantly increased competition, improved market capacity and efficiency, provided access to capital markets to users previously excluded, and lowered the cost of capital world-wide which has greatly assisted in economic development, especially in emerging market countries. These forces, however, have also disrupted the stability and soundness of the industry, resulting in periodic failure of individual firms and a seemingly endless stream of mergers and acquisitions to enable survivors to compete more effectively for market share and dominance. Financial services, however, are too important to their underlying economies to be left to market forces alone. Seeking stability and soundness in financial institutions, governments have regulated the industry from its beginning, but as markets became larger, more complex and global, regulators – never free of budgetary constraints and political influence – fell behind in their ability to understand and control what was going on. As we now know too well, the combination of an aggressive, competitive industry and ineffective regulators can enable market bubbles to form, which on bursting have resulted in financial crises that have endangered the world economy. Three Major Financial Crises There have been three major financial crises in the last thirty years, the first a protracted global banking collapse in the 1980s and 1990s, then the technology
bubble that led to record bankruptcies and a three year stock market decline, and then, only a few years later, we experienced what Economist Robert Schiller called “a particular kind of social epidemic – a speculative bubble that generated pervasive optimism and complacency.” This was the first globally systemic financial collapse since the 1930s. We are still sorting ourselves our from this most recent crisis in which many major financial firms were bailed out by governments to prevent their failure, and economies slumped into severe recessions requiring large government-financed stimulus packages. Four years after the crisis began, the US and European economies are still very weak, the real estate and mortgage finance market is still severely hobbled and financial worries have moved to sharply deteriorating sovereign credit quality, including, for the first time since the Civil War, doubts about the credit quality of the United States. Blaming the Banks The popular response in the US and Europe has been to blame the crisis on the banks for being greedy and irresponsible, and as a result there has been considerable political support of both enhanced levels of regulation of financial services, as well as a blizzard of enforcement actions by regulators, prosecutors, and civil litigants. Before it is all over, the top dozen or so major banks can expect to pay out between $10 and $20 billion in fines, settlement costs and fees. New Sets of Rules The Dodd-Frank Wall Street Reform and Consumer Protection Act is an enormous legislative undertaking, involving 19 separate “titles” and more than 2,200 pages. Originally it aimed to contain systemic risk in the wholesale banking and non-banking sectors where almost all of the institutional failures occurred, but it morphed to include many other elements including the regulation of consumer products, derivatives, hedge funds and bankers’ compensation. The Act created a new regulatory oversight body and added a new consumer protection agency, but otherwise left it to the five remaining financial service regulators to write up some 250 new rules to impose on their sectors. The Congress estimated that it would cost approximately $20 billion to implement the Dodd Frank Act, and provided for this cost to be recovered from the banks, which will have considerable compliance costs of their own. Meanwhile the Basel Committee of 27 central banks has revised its minimum, risk-adjusted standards for bank capital adequacy, tightening both the definition of risks for which adjustments are to be made, and the amount of capital to be held by banks against them. These regulations, which are to be applied incrementally over the next several years, represent a minimum for all banks in the countries involved to meet. Some countries, including so far the US, Switzerland, Germany and Britain have announced enhancements to be applied
to these minimums by “systemically important financial institutions” in their countries. There also have been some significant limits placed on bank compensation programs. As Dodd Frank approaches its first anniversary, it can be viewed as having had very mixed results. Many senior regulatory posts are vacant, including the head of consumer financial product protection. The non-bank systemically important firms have not been identified. Only a few of the many pending regulations have been released, and it is clear that the full force of bank lobbying efforts have been applied to minimizing their impact. There is also increased support for the banks from Republican members of the House of Representatives that recently gained control of that body. But it is fair to say that the principal goal of the law – reducing systemic risk --has been achieved. Regulators are now empowered to impose enhanced capital requirements on systemically important banks and non-banks, and it has the power to force banks to discontinue proprietary trading and investing, which was the downfall of Bear Stearns, Lehman Brothers, Citigroup, UBS, Merrill Lynch, and Fannie Mae. The new law also has required most of the derivatives business to be conducted on organized exchanges, which may reduce the costs to users and require greater and more frequent posting of collateral. And it makes mergers between large banks much more difficult to accomplish. However, apart from the huge cost of implementing the law which is likely to be passed on to consumers and other users of financial services, its critics can focus on the absence of any effort to address the failed government sponsored mortgage finance entities, FNMA and Freddy Mac, and the cumbersome, probably unworkable bank resolution authority, which either wont be imposed early enough to prevent major problems in unwinding a failed bank, or if imposed early enough, might panic the markets into a run on all bank securities. Nor does the law break up any of the five or six largest banks (which now have assets averaging over $1 trillion), to make them small enough to fail, yet it virtually outlaws bailing out any of the these banks if they should get into trouble. Bailouts, of course are deservedly unpopular, but they exist because their alternative – a drastic systemic collapse – would be worse. Back to the Future So, given all this, what does the future look like for the financial services industry? For at least the next ten years, systemically important global banks and nonbanks (not more than 50 or so US firms) are going to be required to carry excess amounts of capital, and be restricted to less risky lines of business, such that the risk of systemic collapse will be much smaller. But this will come at a cost to these firms of a substantially reduced return on investment for shareholders.
Anticipation of this has already driven down the stock prices of the major global banks to such a level that most now trade below their book value and their cost of capital exceeds their return on investment. These banks will have to change their business models to survive, though none have acknowledged this as yet, probably because they are waiting to see what the final set of rules they must live by will be before deciding what else to do. Still, Citigroup and Bank of America have already begun to shed “non-strategic” assets, and last week Brad Hintz, a prominent banking industry analyst, suggested that Morgan Stanley’s shareholders would be better off if the firm liquidated its capital markets division and paid the money out as a special dividend. Most of the large banks, will have to sell or spin off their most risk intense businesses and focus on being steady, low growth public utilities with large market shares in basic lending, underwriting and advisory services. Banks that do this can use technology to lower costs, their global reach to enter expanding new markets abroad, and by minimizing their “black box” trading risks, justify much higher stock prices in the future. Most of the banks’ trading and asset management businesses, which may not be competitive under the heavy capital requirements of systemically important firms, will have to migrate to the non-systemic “shadow banking” sector, where firms can provide innovative and risk absorbing services if they want to, but none will be too big to fail. There are concerns by some observers, however, that the transfer of too much risk out of the controlled into the uncontrolled sector would endanger the system, but I don’t share that concern. The non-systemic sector, which is often the source of new ideas and contains much of the competitive energy of the marketplace, deals with failure all the time without these become systemic. Anyway, if any of them get to be too big, the government has the power to designate them as systemic, which should keep them from doing so. Retail financial services may go through a period of tension between efforts to apply more consumer friendly regulation, and the higher cost and limitations on the accessibility of services that result. But this should achieve its own equilibrium over time. For the next few years, however, the cost of consumer financial services can be expected to rise. That leaves us with the mess in residential real estate finance, which is where the recent crisis began. We continue to have millions of mortgages in arrears or foreclosed without an effective mechanism for clearing the market. This has proven to be much more difficult to sort out than anyone expected, has been bogged down in an impenetrable legal morass, and remains one of the principal obstacles slowing up our economic recovery. The government also needs to resolve the future of FNMA and Freddie Mac. These institutions failed as Government Sponsored Entities, and are operating as government agencies now, carrying most of the burden for national housing
finance. Ultimately the government should get out of this business, but it must recognize the important systemic role played by Fannie and Freddie. The securitized mortgage finance industry is greatly diminished, and urgently needs to be resurrected on a safer and sounder basis than it was before the bubble. Challenge and Opportunity There is a lot of challenge and opportunity facing the broad financial services industry at present. There is room for smaller or boutique firms to take market share away from the larger banks, room for new alignments of products and services and for more entrepreneurial approaches to providing financing services to clients who are going to continue to need them despite the industries forced reorganization. This is already well underway, though the big banks will do what they can to hang on to their market shares. Finally, I would like to add that the Federal Reserve and the Treasury, the principal agents for sorting all this out, have had a very difficult task of developing new approaches to controlling systemic risk without suppressing the energy and innovation of financial markets and doing all this in a divided, often hostile and overly intrusive political environment. Getting a perfect solution agreed would be impossible, even if we knew what one was. What I think they did get is a workable means for avoiding another systemic collapse, though this will require a major adaptation by the financial service industry similar in scope to the Glass-Steagall Act of 1933 that reorganized financial services for more than sixty years. This financial services industry has a long history of adapting to changing markets and regulatory conditions. The future of the industry is assured, I think, as financial services remain in continuous and increasing demand. But it may be that the names of the major players will be quite different in ten years time. When I joined the investment banking business in 1966, there were a dozen large US commercial banks that dominated corporate finance, with 20 or 30 much smaller investment banks handling corporate securities transactions. Today, only one of those US banks or security firms remains doing business under its own name without having relinquished control of its firm to someone else. The game remains but the players change.
