What is clear from the credit crunch is that it started an unstoppable morphing into full blown global financial crisis, unparalleled in history.  The remedies for this will be many and far reaching, with co-operation needed between governments to find ways to mitigate the disaster but also put in place an environment where economies can begin to grow and markets can stabilise.

The downside estimate of the value of the financial crisis is going to take time to finalise but it’s going to be in trillions of dollars and will take some considerable time to take effect.

The part nationalisation of banks is a horror story for most people that believe in free markets but the sheer scale of this disaster demands extraordinary action, unprecedented in the history of markets and governments. The guarantees that governments have provided to the interbank’s lending market is the single most important ingredient of government intervention. It was the illiquidity issues in the interbank space that first demonstrated the looming catastrophe and by providing guarantees, it should start to regain ground and importantly confidence will grow. The return to lending will filter through to industry and the high street and should assist a trickle, in the growth of the housing market. Despite collaborative actions by governments to bring order to the markets there is a certainty that investment banking as we know it, will be no more. A new financial market will emerge, which will be more regulated, with more restrictions on risk capital and greater responsibility on individual board members to understand the financial products and their risks.

What went wrong?

It seems a million years ago when the news first broke about the credit crunch and I think most experts were unaware of how this would eventually escalate worldwide and that we would see governments throwing huge amounts of tax payers money to prop up the individual banks but then realise that the whole financial system was under threat.

How could a severe breakdown of the sub prime mortgage market in the USA lead to the disintegration of the global financial markets?

The answers are many but one thing that is certain is that the integration of financial services throughout world markets escalated the speed of the meltdown, leaving little time for retrospective thoughts and led to actions, which looked like kneejerk decision making.

Mega sized banks that had over many years accumulated multiple lines of vertical business operations were caught failing to recognise early enough, the exposure and risks that they had been caught with. The risk management systems and valuation models created for a market of transparency, were found wanting, when complex products and high risk investment strategies materialised. In short the banks were not as good at risk management as they thought and impotent when it came to taking mitigating actions. The credit crunch put the financial markets on a dead course that led to the financial mulch of investment banks.

The world markets went into free fall, with the end results to the global economy still to be realised, but it’s safe to say they will be really bad. Already many countries are either in recession or heading for it. At best economic forecasts are predicting a recovery in 2010.

Now that global economies have been brought into play the push to recovery will begin in earnest and through a global collaboration of government’s their fiscal policies will first bring stability back into the market and then the evaluation of what went wrong, will begin leading to many changes.

The Credit Crunch in context

It is worth putting the context of the financial crisis, along with the high volatility of oil prices, the growth of economies in China and India and the fragile political situation in the USA, UK and other countries in various parts of the world. In Europe we are also in the throws of redeveloping the financial markets, bringing once stable domestic markets into a massive state of change. It must not be forgotten that in many parts of the world there exists a state of civil unrest and war. The world is a dangerous place today and financial markets reflect the uncertainty and fear of the general population and its financial services agents. 

New Risks or new equations

The inability of banks to manage their own risks within the globalisation of finance has been a crucial factor. The fact that all banks were operating broadly similar risk models has caused a systemic breakdown, unforeseen by central banks, regulators and governments.

New complex financial products were being created, designed to release capital into the economy and with the full backing of governments which camouflaged the reality of the creation of a debt black hole. The credit system operated by banks was based on known values and the acceptance of real estate as good collateral. All was well on the surface but below a deepening amount of systemic debt magma was about to erupt onto the market.

Clearly the accepted valuation and risk models used were flawed with regards to the needs of modern securitisation products and the complexity of these products, making the real risk invisible to risk systems throughout financial services.

The banks now need to analyse deeply the strength and flexibility of their risk management systems. Credit ratings and methods of valuations and hedging have been useless in this crisis. Thank heavens that margining proved an effective barrier limiting the immediate fallout although powerless in overall prevention.  

Benchmarks for valuation and credit now need to be revaluated and probably lowered to ensure more risks are captured. Historical valuations and trends serve little purpose when the financial services industries lurches into unchartered territory as is the case today and new risk models have to be created. Philippe Carrel, EVP at Thomson Reuters says “The industry needs a new set of benchmarks based on observed market moves as opposed to predictive modelling. We suggest setting up an industry-wide database of asset allocations and movements so that everyone can benchmark their own risk concentrations.”

Investment Banking

Investment firms will need to be extra careful and reticent to enter the market until they gain more confidence by the investor but also between themselves. Building confidence has to be the objective of both politicians and the banks and is not a quick fix but will take time and need careful management.

Already this year the AIM market has lost 40% of its companies and this trend looks like continuing. New capital raising by listed companies will be hazardous for sometime, so the most profitable business area for investment banks is going to be in a slump for some considerable time. However, Investment banks have some of the most inventive people in any industry and there is certain to be much thought given to enticing investment. Any new financial product will need to be simplistic as the appetite to go down the road we have just gone down, will not be there.   

For banks to regain their confidence they need to have their security levels increased. The loan guarantees by the government will eventually achieve this, as will the share holding by the tax payers.

The drastic measure to part nationalise the banks has been created by governments to bring order and stability to the banking sector in the short to medium term. The future investment by governments in free markets has a doubtful long term value to the banks or the tax payer.

There has to be a high concentration of effort in creating a new regulatory environment where the banks can begin to recover and where invention is allowed to flourish.

Investment banking as the high risk end of banking will have to suffer the most drastic changes in their operations. It is clear that over exposing their balance against high risk obscure financial products and strategies will no longer be tolerated. A return to vanilla trading might be less attractive to many investment banks but may be necessary to enable the rebuilding of confidence. It is possible that more banking mergers will happen and a period of consolidation for existing banks. However, it is also possible that new financial services firms will emerge from other industries. Already large industrial conglomerates have the trading and dealing room capacity to offer financial services and some also have the balance sheet capacity. The redesign of financial markets might be the perfect to time for new entrants. Philippe Carrel at Thomson Reuters says; “Investment banking is a high risk high reward business by nature. Carrying it out of commercial banks backed by governments is actually a terrifying prospect for the long term. Instead we need a new breed of Glass Steagall act, protecting people’s savings from contamination next time. The 'one bank' model is dead.” 

Liquidity

Liquidity within any market is paramount to the market being successful and it has been the retraction of credit by banks that created a massive decreasing of liquidity within many different markets.

The introduction of huge sums of capital by governments will assist liquidity in the short term but a long term solution is needed that enables the finance industry to use its own resources. Perhaps a solution could be in the way of a new global bank guarantee funded by the G7, G20 or by all banks signing up as a cooperative?

Another solution might be the establishment of a brand new global banking authority with more power than the IMF.

This new authority could monitor the major markets for liquidity pressure or stresses that are being brought about, because of a particular product or bank.

An independent arbiter that can monitor pressure on the global finance system would be able to offer central banks and governments a mechanism to interfere when necessary.

What’s clear is that investment banks need to have a greater degree of regulatory control on the risks they are taking and the impacts on liquidity within financial markets. Banks already need to reset their risk levels to a new low gauge to ensure more risks fall into the risk net, in this time of transition.

New services and technology are urgently required to assist banks and the regulators in the transformation of investment banking. New data that can be applied to new risk scenarios could begin to build new risk models. Philippe Carrel at Thomson Reuters added “Sell-side and buy-side firms need to get a chance to benchmark the risk they take against the risk they should take. This is why we believe our proposed monograph of risk and liquidity concentrations would be a critical change in the approach to assessing risks”

Summary

As the recovery commences there will be a new world order in financial services that may include new players and the evolving of large industrial conglomerates into financial services cannot be ruled out. After the breakdown of the financial services agents there could be a resolve to disintermediate them by the corporates. We have also seen high street supermarkets enter financial services and this could be increased further. Large web based companies could equally see this as an opportune moment to enter the fray.

Whatever, new financial world comes through; the banks will need a complete rethink on the management of risk within markets. We have not been as good at this as we all thought and the disasters today are a cold shower and eye opener to those firms and investors once comfortable. It will be through market expertise and technology that the process to recovery will begin and this is where Thomson Reuters can be a fundamental provider of risk solutions.

The financial markets are certain to recover but a new structure has to be created that recognises the needs of the investor and the ability of the banks to supply innovation to increase profitability.

A new understanding of the risks in financial markets is important but equally also the ability to measure them correctly and to take an active role in ensuring market and product liquidity. We now all know how vitally important to the world this is.      

By Gary Wright, M.S.I