Finance: The Changes to Come

S&P details some of the shifts in markets and regulation that investors can expect as the smoke clears from the financial crisis

The U.S. financial markets will, at some point, look different from how they have looked for the past few decades, but their final shape will depend on many factors, including the successes and failures of an Obama Administration and the depth of the problems the current freeze on borrowing has created.

The players and the regulators are changing, but exactly how remains difficult to determine. The trend toward globalization of financial markets is likely to accelerate, in part because of capital injections from overseas investors into U.S. banks and financial institutions. The trend toward deregulation, on the other hand, seems likely to reverse.

Globalization of financial markets has accelerated in recent years. In 2006, the U.S. took in nearly $1.2 trillion in long-term net investments from overseas. Money managers have become accustomed to searching for the highest yield across currencies and economies. The enormous trade surpluses that oil-producing nations and the Asian economies racked up enhanced this tendency: Funds had to be invested somewhere, and there was no natural home currency to invest in.

Unwinding the Rescue

The federal government's rescue plan, including the Treasury's injection of capital into the banks, is intended to be temporary. How long it lasts will depend on the recovery of the banking system. Although the government has taken nonvoting preferred shares in the banks getting funds, it will have a voice in running the banks, particularly if they look like they are about to get into trouble again. The result is likely to be a more conservative banking system, which is what the Fed wants—for now.

How long the unwinding of these stakes will take depends on how quickly the banks and the financial markets recover. The longer the positions last, the more likely the government is to increase regulation. If the government has a stake, it needs to have a hand in managing its investment. This is an issue not only in the U.S., but also in Europe, where governments have taken even larger stakes in their banks.

Standard & Poor's believes the U.S. government will try to unwind these stakes relatively quickly. The government would like to show a profit, however, which means it will step away only if the banks look profitable and share prices have recovered. The Treasury seems to be planning to hold these stakes for three to five years, which seems realistic, but could be extended if the crisis lasts longer than anyone expects or if another recession intervenes.

It is still possible that the government will begin to refinance mortgages directly, presumably similar to how the Home Owners Loan Corp. of the 1930s operated. It essentially held the bank securities to maturity and ended up making a small profit. This might be done through an existing government agency, whether the Federal Housing Administration or Fannie Mae (FNM) and Freddie Mac (FRE).

The future of Fannie and Freddie is perhaps the most controversial part of the unwinding. President-elect Barack Obama has implied that the agencies have shown they are necessary because the markets have locked up, and he implied that he may keep them under close government control. In this light, they are likely to drop from their current 80% share of the market but retain at least the 60% share they had before their financial problems began in 2004.

Effective Regulation Poses Challenges

Re-imposing regulation on the financial markets will not be easy. Globalization makes it difficult for any national regulator to tighten oversight significantly because the activities can be moved to other markets. More coordination among regulators is clearly required but will be difficult to achieve because of the multiplicity of regulators in the U.S. and abroad.

The Fed has assumed the role of lead regulator in the U.S., but its authority is unclear. Even if other countries were willing to coordinate regulatory policies, it is unclear which agency they should coordinate with. We expect one result of the current turmoil to be a streamlining of the regulatory structure, even if the U.S. does not move to a single regulatory body as Britain has done.

The Basel II Accord was supposed to provide a consistent regulatory structure across countries, but the recent crisis has exposed some of its weaknesses before it has even taken effect. The use of mark-to-market accounting has exacerbated business cycles more than many proponents expected. Market breakdowns have depressed market values, which have hurt bank capital, which in turn has created a greater breakdown of the markets. The risk-management components of Basel II also face criticism, given the losses in both Europe and the U.S., and modifications to the accord seem essential.

Re-Intermediation and Investment Banks

Standard & Poor's expects to see a re-intermediation of the banking system. The U.S. has a lower ratio of debt to GDP than Europe, but the mix is much different because the U.S. has more market debt and less bank debt. The shift away from bank lending has been continuing for decades but accelerated sharply in the past few years. This shift will likely reverse, at least in part. Europeans have always been uncomfortable with the degree to which U.S. banks have moved loans off their balance sheets and are likely to insist on keeping more of the risk at the bank level.

The European model of investment banking appears to have won out, as investment banks have either been absorbed into consumer banks or taken on quasi-bank status. This has been the norm in Europe, bringing investment banks effectively under the control of the central bank. The U.S. has de facto moved to the same model, which is likely to persist.

The combination of consolidation and re-intermediation is concentrating international banking activity. This has been happening in the U.S. for the past 25 years. Since the legalization of nationwide banking, consolidation has cut the number of major national banks to single digits. This has also occurred in most other industrial countries; almost nowhere are there more than 10 major banks. Europe has been moving toward even greater consolidation, as the euro zone becomes a single banking market. How long will it be before the industrial countries become a single market? The survivors are likely to be the banks with the strongest international structures.

Still, small banks continue to thrive, given their natural advantage in dealing with small and midsize enterprises. Lending to small and midsize enterprises demands greater knowledge of an individual borrower, not just its books. In this respect, small banks will probably survive and grow, while midsize banks will be squeezed out.

European models of accounting are also likely to win out in the U.S. Recent problems have increased the credibility of principles-based rather than rules-based accounting—although there is little real evidence that it works better. Mark-to-market accounting may be a casualty as well because it has proved to be very pro-cyclical as markets have broken down and prices have dropped. Recognition of expected losses without full mark-to-market accounting, however, re-imposes the fear that banks will systematically underestimate losses, resulting in misleading financial statements.

Related to this, firms issuing credit default swaps (CDS) have apparently done a poor job of balancing their risks. These instruments were completely unregulated and untracked, and markets accepted the word of the issuers that the risks were balanced. The State of New York has proposed regulating CDS as an insurance product. Another alternative might be to treat them as financial futures and make them exchange-traded, which would guarantee that the risks balance at least overall and make the market much more transparent. The Commodities Futures Trading Commission is trying to regulate such an exchange.

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