Tuesday, June 23, 2009

Guest Post: An Efficiency Revolution Long-Overdue And Real World Implications

Submitted by Günter Leitold

I guess there is a very good chance that there will be fundamental changes to global financial markets within the next 5 to 10 years.

This will not only include adjustments to rules and regulations, the structure of how markets work, instruments and processes, but also include fundamental changes in how participants operate and what the financial institutions of the future will look like.

Part of this belief comes from the fact that the great depression has been a strong catalyst to very important changes in financial markets and their structure, including institutions which have been formed and rules which have been enacted as a response. We indisputably have been and still are experiencing a similar shock to the financial system which will result in material changes.

However, if those changes are for good or bad remains to be seen. If I had to guess I would expect changes not to be perfect but to be more likely on the good side than on the bad. Would I want to leave this bet unhedged? Certainly not!

The common belief seems to be that banking will become a business very similar to the utility business and far less dynamic than it was over the last decade.

I do not disagree that growth of banking over the next years will be dismal but I don't buy the utility portion of the now common belief.

My strong conviction is that financial institutions will look completely different within the next ten years and that the leading players of today will not necessarily be among the leading players then. I cannot come up with an exact description on what they will look like but I can come up with my reasoning why I think such big changes are ahead.

Finance has always been very dependent on technical developments. Achievements in paper manufacturing, postal services and computer technology have historically all been big influences to financial markets.

One of the most fascinating observations which I have made over time is how sophisticated financial markets and participants present themselves, and how dumb and inefficient they actually are and/or behave. I could present up a myriad of examples:
  • bond salesmen calling investors day in and day out without the slightest idea what they are talking about
  • a majority of equity investors buying and selling securities of companies which they don't understand and/or analyze
  • huge risk transfers are taking place based on thousands of pages of financial disclosure and prospectuses which most people don't read, don't understand and are grossly meaningless (I don't even want to mention accounting)
Want an example? Take bank equity. Investors subscribe to bank equity offerings without the slightest chance of knowing what they are getting themselves into. Another good example is the bond market. Professional bond investors receive thousands of Bloomberg messages daily including indications of interests for a huge universe of bonds. The format of how this information circulates and how market participants process it is far from efficient and, together with financial disclosure in general, reminds me very much of less-than really interested hobby stamp collectors. The way investments are managed and risks are transferred is in the process of changing but it is still very far from being efficient in my view.

However, my guess is that the huge debacle of this great financial crisis will be a catalyst to narrow the gap between the status of how things in financial markets are done today versus the full potential of what would be doable (I mean the dynamic element of the business apart from the utility portion or functions everybody is talking about for which I see a great demand).

I warn you that I personally have been dead wrong on this before. I and some others thought the way bonds are traded is just dumb and created (as about 50 others in the same year) a web based market place to efficiently trade less liquid fixed income securities. I spectacularly failed with almost zero revenues and so did about 96% of my peers within the 3 years after they started.

Bob Shiller, in one of his Yale economic courses (to which you can listen online) told a story about an inventor who had the simple and obvious idea to put wheels beneath larger suitcases. This actually took place in 1972, so quite some time after the invention of the two separate components: the wheel and the suitcase.

The inventor said that the department store people to whom he wanted to sell his idea thought there would not be great demand, because in every railway station there are people specialized on moving luggage at a small cost. This reminded me very much of some of today's financial markets, systems and participants.

When especially big changes occur, there is a tendency for incumbent/leading market participants to be challenged by new and more flexible entrants (remember Amazon and others). Interesting times ahead and I certainly think that utility banking will not be the only outcome.

The GDP of the US versus the Eurozone are not too different. However, the securities market in the US (total outstanding USD 13 trillion) has developed to a much larger portion of the US financial market (total loans and securities of 26.5 trillion) compared to Europe's (securities USD 3 trillion and loans and securities USD 23.8 trillion) and I think it is a given fact that the US financial market is more developed. It seems that the US securities market has been better in developing trust versus the European market, which is dominated by traditional banking.

In this downturn asset markets deteriorated very synchronized and to me it is astonishing why IMF etc. expects significantly lower losses in Europe's financial system, even when Europe shares US losses to a larger extent than the US shares Europe's losses and while the securities markets (with their larger portion in the US) help to more broadly distribute those losses. The expected cumulative loss rate (in percent of total assets) is 10.2% for US and just 5% for Europe. I have absolutely no clue how this estimates can make any real world sense. The ECB in it's most recent European Financial Stability Review seems to subscribe to the same nonsense.

Securities markets, in my view, are more resistant towards the general tendency of "being in denial" when it comes to recognizing losses than non-securitized parts of the financial markets, which is why - in regards to the above mentioned developments going forward - I expect somewhat more trouble in Europe. Japan too has a proven track record of denial (expected loss rate of 7%, securities markets almost non existent) and may also have a hard time to adjust while emerging markets, in my view, are well positioned to adjust to such changes given that their financial and banking systems are less troubled. Sphere: Related Content
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