The Bankwatch

Tracking the consumer evolution of financial services

The Great Unwinding | part 1 of 3: 2009 – 2012

This will be series of posts focussed on the current state of banks, the impact of the banking crisis on banks, and future scenarios for banks 2009 – 2020.  This is no longer banking as usual.  The research used to source is primarily from The Future of the Global Financial System together with supporting data from G20, and IMF.  I also acknowledge strong influences from Niall Fergusons “The Ascent of Money” and his other writing here at the Financial Times plus John Mauldins pragmatic view of the world.

The WEF and IMF reports are stored on the blog here.  The only reason for a series of posts is that this is work in progress and the posts would be too long otherwise.  As to why I care – I care because the future of financial service innovation will be impacted.  If your bank is to become like the gasworks around the corner, where will be new thinking come from?  Before we get to that, we need to understand the degree of change we are undergoing here.

The Great Unwinding

Why that title?   Let me say there is no political bias here – the imbalances that produced the growth over the last 20 years lie in these areas:

  1. expansionary monetary policy (excessive money supply)
  2. expansionary fiscal policy (reduced taxes)
  3. excessive financial deregulation
  4. ill considered use of credit and leverage

To place this in perspective consider – asset values represented by equity and financial market investments plus real estate values have reduced by 30 – 70% in aggregate depending on where in the world you are.  Meantime debt levels are substantially unchanged.  Thus leverage has increased exponentially and standard credit practice requires this to be rebalanced.  Hence the Great unwinding of leverage to return us to normal.  We can forget about new debt being sought to solve the leverage problem because new debt increases leverage.  This may offer context for governments complaining about banks restricting credit – in fact they are simply doing what is right for people, business and the economy.  Debt is always tied to ability to repay through asset value or income.   Anything else would be tantamount to negligence resulting in immediate bankruptcy.

Unfortunately levels of debt in the world have increased to levels that make no sense.  In the US credit market borrowings have increased from 160% of GDP to 350% of GDP in 2008.  This increase has been roughly equally distributed between consumer debt and financial services debt.

The Great Unwinding is directed at consumers and banks.

The result of the crisis to date is the G20 agreement last November to focus on three implications for the financial system:

  • expanded scope of regulatory oversight
  • constrained financial institutions
  • increased global regulatory co-ordination

To Big to Fail

The overall context for financial services will be seen through the lenses of regulatory increases, back to basics banking, and structural changes for financial services that we have not anticipated.  The law of unintended consequences will get a full workout for the next 20 years.  Global governments will be expected to zero in on this attribute of Too Big to Fail, which implies certain banks are of “systemic importance” to the country or the world.

This will effectively split the financial community into two distinct sets:

  1. financial utilities – significant operating restrictions in light of implicit and explicit government guarantees underpinning the business
  2. risk takers – not clearly defined as yet – will be dependent on regulation applicability

Those risk sets will provide a high level model overview so lets consider some models and model attributes.

Financial Utilities

Heightened disclosure requirements to ensure transparency of all risks and that those risks are mitigated.  They will be required to devote capital to liquidity and upgrade coverage of market, credit and counterparty risk.  This will result in significant or complete elimination of complex and hard to value securities of the likes of ABCP and derivatives.  Off balance sheet vehicles will be much less prevalent.  The deleveraging of banks involves elimination of derivatives.  The debt level of the world has to be reduced.

Generally the outcome will be that these institutions will not be able to grow their business and their assets faster than their capital base. Instead investments in assets (loans) will be reduced to reflect capital levels as consumers and business deleverage too.   This will represent a return to basic banking.

Financial utilities will be forced to hold more capital against assets relatively than they are today.  Look for changes in the Basle accord.

Finally these utility banks will be required to hold additional liquidity with caps on short term funding reliance.  The report notes this is already resulting in intense competition for deposits and longer term unsecured funding.  One outcome will be higher cost of capital for these financial utilities resulting in narrower spreads.

A final note here applies to smaller banks, particularly to the US with 8,000 + smaller banks, who are each small enough that they do not individually pose systemic risk to the economy.  Those banks will be forced to minimise and manage growth to remain small, or seek alternative business models to survive.  This could pose the first glimmer of hope in this otherwise dark picture of the world of financial utilities.  More on this in later Parts.

Back to Basics Banking

Trends to watch for here are investment bankers refocussing on client business and away from business as a principal.  Their traditional roles of corporate finance, advisory, brokerage and asset management driving fee revenue will be front and centre.  The business where the investment bank would operate as a principal taking positions in commodities, equities, ABCP, CDO’s and derivatives is likely to be a distant memory.  If that bank is in the utility category this will be prohibited by their government superiors and regulation – if they are outside the utility model acting as a principal will be deemed too risky by internal corporate governance.

Investors will ensure the separation of customer deposits from investment banking capital.  Even if there are loopholes in new regulation that might permit mingling of retail deposits and investment banking, smarter investors who have been burned once will not permit that to occur.  The practice of aligning like capital with like investment categories will return to the fore.

Two stages

We can expect the process to follow two stages.  The first will be one of repairing damaged balance sheets. Expect capital raise requests, reduced lending supported by reduced lending demand, and periodic asset write downs as loans and toxic off balance sheet items have their negative impact brought into the income statement and capital account.

This will be iterative because there is no practical way to attribute the entire impact of the 2009 depression in one balance sheet snapshot.  The only practical way to do that is to value any banks assets at zero which is clearly an accounting exaggeration.  However in absence of absolute clarity forcing banks to ‘mark to market’ for all asset categories that would drive out incredulous results, expect this continual iterative deleveraging, and becoming smaller as a good thing.

Across the globe the write downs through this crisis of nearly 1 trillion US dollars exceed new capital raised by a mere $78 billion – translation – the capital raises and write downs are managed to roughly balance.  It should be noted that if the write downs are driven to exceed appetite for the capital raises we will have an entirely new crisis and note this has a fair probability of occurring with Gordon Brown pressing banks on just this aspect to the point that British banks are almost valued at zero now.  Such events surely drive the financial utility model to arrive sooner and more broadly across more banks than might otherwise be the case.

The second stage will see ‘repaired’ banks’ refocus on client centric activities.  This period will offer some new hope for innovation, tempered by the limitation associated within those that are relegated to existing as financial utilities.

Relevance to Bankwatch:

Banks as we know them will cease to exist in the coming years to 2012.  While we will still see banks on the corner and on the web, see debit and credit cards in our wallets, the organisations behind those facades will not be the same as before.  These organisations will be engaged in a desperate shift to deleverage – to reduce debt.  The result will be dramatically smaller balance sheets than we see today.  Better measures than return on equity will be used to follow success or failure – I expect to see “debt to equity” which has been traditionally forsaken in banking to return as a central measure of comparison between banks.

We will have some banks driven by government ownership with those that are not ‘owned’ to be driven by Central Bank influence.  These influences during this time period will align with consumers desire for security and safety as confidence gradually returns to the economy.

There will be differences between US and Canada, and UK and the rest of Europe but the directional trend will be similar towards large banks becoming financial utilities offerring banking as hydro companies offer electricity – reliable, safe and always available.  The internal focus in those organisations will be fierce working to ensure their government masters are satisfied, and the likelihood of new innovative products or services is very low.  The appetite for risk will be reduced to zero during this period.

The unknown remains those that are not in the ‘too Big to Fail’ / government owned financial utility category.  Largely composed of smaller banks and credit unions, this group offers potential for innovative change while the others go through the balance sheet repair process and seek to build sufficient equity to buy out their government masters.

Part 2 – will focus on what we can expect to see beyond 2012.  The Future of the Global Financial System report highlights four scenarios that cover the range of expected outcomes, and that will be the backdrop.

As always thoughts, analysis, and views always appreciated.  This will be the most challenging series I have done, and I expect to miss stuff so assistance is welcomed.

Written by Colin Henderson

February 4, 2009 at 22:47

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  1. […] do worry about the debt levels in the world [The Great Unwinding], reflected in the banking system.  The pending impact of revaluation of that debt to accomodate […]

  2. […] a comment » In the first real appearance of specific moves towards the inevitable Great Unwinding RBS announce plans to reduce their balance sheet by […]

  3. […] There are some dire predictions in this piece.  In any event it is a reasonable summary of the conditions that Community banks in particular in the US face.  I have pasted fairly extensively but bolded some key highlights for ease in locating points of interest. Note the reference to ’systemically important” banks, and “removal of bad assets” which point in the direction of the large banks becoming financial utilities. […]

  4. […] and supported the idea that the inevitable nationalization of the sloggers, will result is a set of financial utilities, more akin to electricity and water providers to your […]

  5. […] I keep going back to the predictions formed based on my own research over the past 2 years and summarised here in Feb 09, that, broadly, concludes we will see two tiers of banking service models. … however […]

  6. […] in UK and US, the influence of government is significant within large Banks, and as discussed earlier, the arrival of the political dimension is […]

  7. […] prefer to think of this as a shift that will profoundly change things for the next few years, with some good and some not so good elements in that shift.  It may be […]

  8. […] prefer to think of this as a shift that will profoundly change things for the next few years, with some good and some not so good elements in that shift.  It may be […]

  9. […] has become more of a factor in oversight of banks.   In my three part piece earlier this year, The Great Unwinding, (title refers to unwinding of debt and deleveraging of households and institutions) the point was […]


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