This is, by general consensus, about the worst time to be a broker since 1929 – and possibly since 1914 and the start of the First World War. Both retail brokerage and prime brokerage firms have been kicked around by the crisis of the past few months, and both will emerge changed, even ignoring the way some firms have simply disappeared off the map. There is going to be a much more risk-averse culture from clients and among the owners of brokers, there is going to be greater pressure on analysts (who might find their remuneration changes to “payment for accurate prediction”), and there is almost certainly going to be regulation to ensure firms have to measure risk better, and show that they are measuring risk better.
After all, if even Alan Greenspan, Chairman of the Federal Reserve Bank for 18 years until 2006, confesses himself “in a state of shocked disbelief” over the global financial crisis, then one can be safe in drawing the conclusion that the system did not work the way it was meant to. Mr Greenspan said as much himself, on October 23, when he told a congressional committee in Washington that he regretted opposing regulatory curbs on the types of financial derivatives that led to banks in the US, the City of London and elsewhere with billions upon billions of dollars of liabilities. “I made a mistake in presuming that the self-interests of organisations, specifically banks and others were such that they were best capable of protecting their own shareholders and their equity in the firms,” Mr Greenspan told Congressmen on the House oversight committee.
The problem, as Mr Greenspan now seems to be realising, is that you can only assess risk, and protect your company and your shareholders against too much risk, if you understand the game that is being played. Those at the top of banks knew too little about what their subordinates were doing in bundling up all sorts of derivatives and trading them on.
They believed what they were told about the risk, or lack of it, in these new sorts of financial instruments. They did not understand how what was being bought and sold in their companies’ names really worked, and so they were unable to make a judgment on their real safety. Nor did they have in place systems to properly evaluate and report on the risks these instruments really posed. Instead, they saw the large profits being made, and ignored any qualms they may have felt, until suddenly too much of what was being passed as prime assets turned out to have the solidity of dry sand. Trust collapsed, as banks realised they could not believe their fellows’ balance sheets and could not be certain to get any loans back, and credit – which relies on trust – dried up.
If and when the dust settles
With so powerful a free-market flagwaver as Mr Greenspan giving the nod towards greater regulation in a post-credit crunch world, there seems little doubt that financial institutions are going to be working in a very different regulatory environment once the dust finally settles after the collapse of such former banking giants as Lehman Brothers, with debts of more than $613bn.
On the other hand, as Mr Greenspan also told the congressional committee, in words rather less widely reported than his comment about “shocked disbelief”, self-interest, properly applied, is still more powerful than regulation: “Whatever regulatory changes are made,” he said, “they will pale in comparison to the change already evident in today’s markets. Those markets, for an indefinite future, will be far more restrained than would any currently contemplated new regulatory regime.” Clients are going to remain risk-averse for a long time, and the leaders of financial institutions are going to be ensuring their own organisations are pursuing risk-averse policies for a long time: even without legislative compulsion to do so, out of protective self-interest banks and other financial institutions are going to set up internal systems to review risk much more thoroughly than they have been doing.
That is unlikely to be enough for politicians. Already some are fearing a knee-jerk rush by governments and legislators to, effectively, punish the global financial services industry with new regulations as a payback for the pain the perceived excesses of the banks and financial institutions are causing the world economy right now. One US politician, the Republican Congressman Chris Shays, spoke for many when he told the House Financial Services Committee on regulatory reform at the end of October: “No one has the right to juggle knives on a public bus.” Attacking the highly leveraged share dealing practised by hedge funds and backed by prime brokers such as Lehman Brothers, Mr Shays said that “high-risk ventures that threaten systemic integrity need to be fully capitalised by their private sponsors or prohibited altogether.”
Despite bankers’ natural aversion to regulation, there is unlikely to be too much fuss made about new regulatory oversight of risk and risk management. The financial world is so interlinked that, just like in the child’s game Ker Plunk, pulling out one vital stick can suddenly make the whole thing collapse. Banks are likely to say: “We know we’re all right, but we want new regulations to prevent our rivals from putting themselves, and us, in danger.” Tim Ryan, Chief Executive of the US Securities Industry and Financial Markets Association, one of a number of trade groups representing brokers, banks and insurers. Who gave evidence to the House Financial Services Committee on regulatory reform, called for “a financial-market-stability regulator that has access to information about financial institutions of all kinds that may be systemically important, including banks, broker-dealers, insurance companies, hedge funds, private-equity funds and others.”
Advocates of the idea of a new “systemic regulator” disagree whether or not there should be a “market stability regulator” separate from a body focused on business conduct; and indeed whether there ought to be two separate stability regulators, one for banks, broker-dealers, hedge funds and other securities industry participants, and another for “systemically important institutions”, which would include larger hedge funds and other financial entities that “could not be allowed to fail”. How you define “too important to be allowed to fail”, though, will always be a political rather than a financial choice: it looks as if Lehman’s was allowed to fail because it happened to be the first (or at least the first far enough after Bear Stearns): other banks were shored up, not because they were more important than Lehman’s but because their collapse right after Lehman’s would have brought a general run on the entire financial system.
Speaking to the same congressional committee as Mr Greenspan, Christopher Cox, Chairman of the US Securities and Exchange Commission, declared: “We have learned that voluntary regulation does not work.” Regulation on broker-dealers and their investment bank holding companies “must be mandatory, and it must be backed by statutory authority,” he said. The holding company in the case of Lehman Brothers, for example, Mr Cox said, consisted of more than 200 subsidiaries, including over-the-counter derivatives businesses, trust companies, mortgage companies, offshore banks, broker-dealers, and reinsurance companies. The SEC was not the statutory regulator for 193 of them. The current regulatory system is “a hodge-podge of divided responsibility and regulatory seams” where coordination among regulators is difficult, and a new scheme is necessary, he said. Mr Cox wants to abolish “outdated” laws that treat broker-dealers “dramatically differently” from investment advisers.
Paradoxically, part of the blame for the current crisis is being put on a complicated piece of regulation introduced by the Federal Accounting Standards Board in the US and enforced by the SEC, supposedly in the name of transparency, covering “marking to market”, which regulates, among other things, how banks value every day the assets they hold and how brokers value assets and make margin calls on accounts. Critics, such as William Isaac, former chairman of the Federal Deposit Insurance Corporation in the US, which guarantees bank deposits, claimed that the Securities and Exchange Commission’s “senseless” insistence on firms “marking to market” assets for which there was no proper market to assess value by that has destroyed $5trn of bank lending. Mr Issac said: “That’s a major issue in the credit crunch right now. The banks just don’t have the capital to start lending, because of these horrendous markdowns that the SEC’s approach required.” The problems with regulating the proper valuation of assets whose real value can’t be known until they are sold at some time in the future by marking to an effectively imaginary market, whether or not those regulations added to the credit crisis, certainly show that framing regulations without running into the Law of Unintended Consequences is not easy.
There is certainly going to be a new take on risk from all sides of the financial world. Hedge funds, who might have been expected to know more about risk than anybody – after all, it is meant to be how they make their money, evaluating risk more accurately than the market as a whole – found themselves badly hammered when a risk they never expected, the bankruptcy of Lehman Brothers, the biggest in the world reared. Many hedge funds used Lehman’s as their prime broker, and found their assets stranded when the bank went down – assets of up to $1.5bn for a single fund, in some cases. At least one hedge fund is said to be closing, because of Lehman brothers’ bankruptcy. Since the rule now has to be “if it can happen to Lehman’s, it can happen to anybody”, clients who use banks for prime brokerage operations in future are going to be putting pressure on those banks for greater transparency, and better safeguarding of their funds.
The prime brokerage market was previously dominated by three big American players, Goldman Sachs, Morgan Stanley and Bear Stearns (sold to JP Morgan Chase in March this year for $10 a share, down from $93 a share only a month earlier, after investors’ confidence evaporated in the face of the sub-prime mortgages crisis). Going forward, the industry looks likely to be divided up more evenly between six key players, with hedge funds spreading their own assets around these six firms rather than having a single main prime broker.
Retail brokers have been surprisingly busy so far this year, with volumes high even as prices plunged. Many brokers derive a high proportion of their revenue from trading fees, so that prices are of less concern than they might at first appear. But with the storm that has taken place in September and October likely to lead to a reduction in retail trading, brokers could see fee income fall, at the same time as lower interest rates hit the amount they can charge for leveraging loans.
If clients prefer to sit on their assets, or seek safety outside stock markets, then the retail brokerage industry round the world is going to see a wave of closures and mergers. There are certainly not going to be too many company flotations to keep brokers busy over the next few months.
Not everybody agrees that more regulation is the way forward. The FSA in the UK stepped in quickly to ban short-selling during the crisis, but Hector Sants, head of the organisation told the Hedge 2008 conference in London at the end of October that increased regulation is not needed. “There is pressure for more regulation in a rather general way,” he said. “I don’t particularly think more regulation is needed, but I do think more effective regulation is needed.” What exactly the difference between “more” and “more effective” was, Mr Sants did not say. But he stressed the need for tighter control and increased vigilance by risk managers in the affairs of banks and broker-dealers, However, with the Bank of England announcing that it will be asking for more powers from the government to intervene directly in markets, it looks as if, in the UK at least, there is going to be a clash between the still laissez-faire FSA and the interventionists in Threadneedle Street.