In finance, things change. Forty years ago you couldn't buy a futures contract based on a currency, 25 years back the first collateralized debt obligation hadn't hit the market, and two years ago subprime wasn't a curse word on Wall Street.
But investors—and the folks who make money by packaging new investment products—always seem eager to move on to the next big thing. If financial history has taught us anything, it's that change is inevitable—change in everything from the way banks package risk, to the way governments regulate savings institutions, to the ways consumers can invest their savings. And with the recent upheavals in equity and fixed income markets, the financial industry is left to ponder: What change is next? What will the financial world look like in 2020?
The quick answer is an industry more transparent, more international, and more driven by individual investors than today's.
BusinessWeek asked financial professionals and academics their thoughts on what the financial landscape will look like in the year 2020. The experts foresee a world where investment banks will look more like government-backed depository institutions, mutual funds will be fewer, and stock exchanges will become international with super-governmental bodies regulating them. "A lot of the frameworks and walls built because of the old financial world we grew up in will come down," says Tanya Styblo Beder, chairman of the SBCC Group and a member of the board of directors at the International Association of Financial Engineers.
One barrier that will fall is the distinction between foreign and domestic finance. Since 2000 developing nations have gone from producing 37% of the world's economic output to 45%, according to the International Monetary Fund, signifying a trend of greater parity between developed and undeveloped nations. With explosive growth in emerging markets and more companies with worldwide operations, a corporation's official "headquarters" will become less relevant, says Jeremy Siegel, a professor of finance at the University of Pennsylvania's Wharton School. "People think they're diversifying by investing in a country, and it leads to inadequate diversification," he says, "because the country of origin or incorporation is not the primary influence on the stock price."
More important for individual investors will be understanding where a company produces and sells its products, since an outfit based in France but selling products in Egypt doesn't truly represent the French economy. Siegel foresees the birth of the "international corporation"—a business globally diversified in where it produces and sells goods and not identified by its specific country. That, in turn, will necessitate a worldwide stock exchange, he says, and international accounting standards will become the norm. "We'll be thinking in terms of global markets all the time."
Yet the disparities today between regulatory bodies in emerging countries and developed ones will have to change, says Ravi Jagannathan, finance professor at Northwestern University's Kellogg School of Management. Many emerging economies haven't proven that their financial laws have teeth. So as wealthy people age in developed countries, they will want to invest their savings in countries with solid legal institutions that can enforce financial contracts. But "if you have young people in India, Africa, or Latin America borrowing from [the wealthy]," he asks, "how will the wealthy enforce those financial contracts?" Many of those emerging economies don't have the legal infrastructure to ward off corruption or reneged contracts, says Jagannathan. The answer will be a super-governmental international organization with executive powers, he says, which can oversee the flow of money across national borders. Think U.N. meets the Federal Reserve.
For the U.S. financial industry, one near-term possibility is that investment banks will start to raise funds via public deposits, says Charles Calomiris, finance professor at the Columbia School of Business. His reasoning: the Fed's willingness to salvage Bear Stearns and its decision to prop open the discount window in March signaled its increasingly hands-on relationship with investment banks. Banks like Goldman Sachs (GS) or Morgan Stanley (MS) do not raise funds through deposits but instead sell securities to private investors. That system traditionally avoided the "increased regulatory pressures" that deposit-taking commercial banks face, says Calomiris, but the system proved disastrous when the market for mortgage-backed securities dried up.
"The Other Shoe"
"Investment banks are no longer able to avoid prudential regulation, since Bear Stearns was just hugely regulated and primary dealers that are investment banks now have access to the discount window [Fed's borrowing mechanism]," says Calomiris. So if banks are forced to face increased regulation, their logical next step would be to embrace the benefit of federally backed deposits, as he says: "The other shoe has to fall, too."
Transparency will come to rule the financial world, say experts. Banks are afraid to lend today because they hold many customized over-the-counter assets (like collateralized debt obligations and credit default swaps), whose value is tough to gauge without a ready buyer. New financial products, says Calomiris, will be less arcane and more homogeneous so that buyers know exactly what they are buying and sellers know exactly what it is worth. Things like CDOs will be able to be traded widely and their value will be determined immediately by larger markets—so that, for instance, a banks' management can know how much a CDO is worth at any given time on an exchange. "A movement toward simplicity is going to improve liquidity," he says. "So instead of having 50 different ways to do a credit default swap, you could actually buy one on an exchange."
Mutual funds might diminish, too. Today, increasing numbers of investors are diversifying their portfolios by purchasing exchange-traded funds (ETFs), baskets of stocks whose value corresponds with a broad index like the Standard & Poor's 500-stock index. In 2000 there were 80 exchange-traded funds that held roughly $45 billion in assets, according to the Investment Company Institute. Today there are 697 such funds holding $578 billion. As investors flock to the funds' low management fees and built-in diversification, actively managed mutual funds that charge higher fees will lose their appeal. "You will find the actively managed mutual fund industry shrinking pretty dramatically," says Darrell Duffie, finance professor at Stanford's Graduate School of Business. "And individuals will become more capable of managing their own financial affairs."
Greater Trading Transparency
But actively managed funds won't disappear because there will always be a need for packaged financial products, says SBCC's Beder, since "a lot of people can't access the full range of products in a market." All of these changes toward greater efficiency and transparency in trading will build more diverse portfolios: those that are "more robust across a broader range of market conditions," according to Andy Weisman, chief investment officer at WR Capital ,
Better software will let everyday investors visualize how their portfolio's risk is altered by the slightest tweak, says Duffie. Interactive charts will show investors how their risk exposure changes when they buy more Microsoft (MSFT) options, or hold fewer Chinese stocks, or short the price of oil. "People will click on an icon and visualize their financial future in terms of all scenarios," he says. New tools will also better reflect the correlations between different parts of investors' lives. "The idea that you just buy medical insurance on the one hand and invest in financial securities on the other will vanish," he says. People will be able to buy securities that pay off based on changes in their medical expenses, or they will be able to buy insurance against a reduction in their home value. Says Duffie: "Just use your imagination."
The subprime disaster reinforced that reactive thinking can't avert a financial meltdown, and diversifying risk is still an imperfect art. The hope for the future, says Robert McDonald, professor of finance at Kellogg, is that regulators will respect markets' need for competition and freedom while not turning a blind eye to their bad habits. "You can hope that a phoenix will arise from the ashes," he says. "The challenge will be to fix things without breaking them." Yet Robert Wright, a financial historian at New York University's Stern School of Business, thinks a regulatory fix will be elusive, as he puts it: "Regulators always tend to fight the last panic."