Opinion

Mohamed El-Erian

Prepare for a different financial landscape

By Mohamed El-Erian
December 5, 2011

By Mohamed El-Erian
The opinions expressed are his own.

With the European crisis continuing to dominate the news, many people now realize that today’s global economy faces an unusually uncertain outlook. Indeed, Europe’s turmoil is but one of the multiple global re-alignments in play today. What may be less well recognized is the extent to which specific sectors are already changing in a consequential and permanent manner.

This is particularly true for global finance where volatility has increased, liquidity is evaporating, and the role of government is pronounced but inconsistent. This is a sector where the functioning of markets is changing, along with the outlook for institutions. The implications are relevant for both economic growth and jobs.

The recent volatility in financial markets – be it the dizzying swings in equities around the world or the fragmentation of European sovereign bonds – far exceeds what is warranted by the ongoing global re-alignments. We are also seeing the impact of a consequential shift in underlying liquidity conditions – or the oil that lubricates the flow of the credit and the related ability of savers and borrowers to find each other and interact efficiently.

Facing a range of internal and external pressures, banks seem to be limiting the amount of capital that they devote to market making. Combine this with the natural inclination of many market participants to retreat to the sidelines when volatility and uncertainty increase, and what you get is a disruptive combination of higher transaction costs, reduced trading volumes, and abrupt moves in valuations.

We are also witnessing a loss of trust in instruments that many market participants – from corporations to individual investors and institutional ones – use to manage their balance sheet risks. The reduced ability to hedge current and future exposures is even forcing some to transition from using markets to manage their “net” exposures to simply reducing gross footings.

Meanwhile western banks, whether they like it or not (and most do not), are now embarked on a journey – away from what some have called “casino banking” to what others label as the “utility model.” Whether in America or in Europe, banks are under enormous pressure from both the private and public sectors to become less complex, less levered, less risky and more boring.

By withholding new credit, private creditors are forcing certain banks to de-lever – a process that is amplified by the sharp decline in bank stocks and the accompanying erosion in capital cushions. At the same time, the banks’ traditional global dominance is under growing competitive pressures from rivals headquartered in healthy emerging economies.

The result of all this is a further, across-the-board shrinkage in the balance sheet of the western banking system. This is led by Europe where some institutions (e.g., in Greece) are also experiencing meaningful deposit outflows.

After the 2008-09 debacle of the global financial crisis, governments also want their banks to be better capitalized and more disciplined. And while implementation has been both far from consistent and less than fully effective, the intention is clear: Much tighter guardrails and better enforcement to preclude any repeat of the wild west experience of over-leverage, bad lending practices, and inappropriate compensation approaches.

The influence of central banks and governments are also being felt in other ways that impact the functioning and efficiency of markets. Some of the implications are visible and largely knowable while others, by their very nature, are unprecedented and therefore less predictable.

For three years now, central banks have been pursuing a range of “unconventional policies,” particularly in America and Europe. The goal has been to reduce the probability of prolonged recessions and severe financial dislocations.

In doing so, central banks have gone well beyond their prudential supervisory and regulatory roles. They have become important direct participants in markets – essentially using their printing presses to buy selective securities, and doing so not on the basis of the usual commercial criteria that anchor the normal functioning of markets.

Market predictability is also being impacted by the erosion in the standing of sovereign risk in the western world. The cause is the twin problem of way too little economic growth and way too much debt. The effect is a less stable global financial system now that there are fewer genuine “AAA” anchoring its core.

All this will translate into a very different financial landscape. The change will be most pronounced for banks.

Look for western banks to be less complex, less global, somewhat less inter-connected and, therefore, less systemic. With some banks teetering on the edge, certain European governments (e.g., Greece) will have no choice but to nationalize part of their financial system.

Also, with the western banking system shrinking in scope and scale, look for new credit pipes to be built around those that are now clogged. With the aim of supporting growth and jobs, particularly in longer-term investments such as infrastructure, some of these pipes will be directed or enabled by governments.

Have no doubt, the financial landscape is rapidly evolving. Some of the changes are deliberately designed and implemented. Others are being imposed by the quickly changing reality on the ground.

The ultimate destination is a smaller and safer financial services sector. When we get there, a better balance will be struck between private gains and the common good. Banks will be in a better position to serve the real economy without exposing it to catastrophic risk and harmful abuses.

The next few months will shed light on the extent to which governments and, to a lesser extent, business leaders are able to properly orchestrate the process. The more they fall short, the less growth and fewer jobs there will be.

Photo: A money exchanger speaks on the telephone in his shop in Sanaa January 5, 2011. REUTERS/Khaled Abdullah

Comments
11 comments so far | RSS Comments RSS

“a better balance will be struck between private gains and the common good”

I hope you mean less greed, not more!

Posted by RobinGitte | Report as abusive
 

“The ultimate destination is a smaller and safer financial services sector. When we get there, a better balance will be struck between private gains and the common good. Banks will be in a better position to serve the real economy without exposing it to catastrophic risk and harmful abuses.”

Here in America the bankers, Wall Street, their lobbyists and their cronies in office will fight this tooth and nail.

“The cause is the twin problem of way too little economic growth and way too much debt.”

The West particularly needs to change the meme away from a model of debt and consumption. Sustainability should be the mantra of the future if we are to have one.

Posted by TheUSofA | Report as abusive
 

Perhaps another way to summarize the point of the article is that governments are trying to recreate financial institutions that common people can have faith in, and to isolate “cowboy” bankers and swindlers from the public pool of tax money.

In the USA, if there are any honest banks, it is not apparent. They mainly seek “bailouts” from financial disasters they themselves, sometimes deliberately, create. Until these people are stripped of their ability to raid the Treasury, the USA will be in perpetual crisis.

Posted by txgadfly | Report as abusive
 

sure, just less rich… but also, less greedy?

Posted by robb1 | Report as abusive
 

The bank’s behavior is simply a reflection of our own behavior. Just as a politician will vote for whatever first benefits himself, then his party, then his district, then his state, our banks behavior represents our own motives that result in self destruction.

Like wars that are fought until both sides tremble with exhaustion, our economic destiny will always be based on how each of us abuse the system. The only law that really prevails is the law of “survival of the fittest”.

As some wise old man once said, “The difference between an optimist and a pessimist is experience”.

Posted by Custerluck | Report as abusive
 

Banks and financial system went too far in one direction and caused collapse and harm to all of us. As expected from human nature and system correction, government regulations and public pressure are pushing the financial system in the other direction and putting the banks into their ‘real’ size or smaller. With the shrinkage expected, many groups who ride the financial system to power may suffer. How long the shrinkage would be be until we forget/forgive the collapse and allow the system to go back to its hyper situation. In the mean time the financial system will find ways to squeeze profits directly from the common people instead of making them pay hefty at a collapse. The dilemma of extreme capitalism exposed by expanding China and other forces.

Posted by OmarMinyawi | Report as abusive
 

Good article. But there are many smaller banks in America that did not participate in the free-for-all that eventually and predictably led to the mess were in. I’m a small business owner and I refinanced my commercial mortgage in Nov. 2010, I received favorable terms and a low interest rate. I had to switch small banks because my old bank over-levered themselves with questionable loans and had to ask for bailout funds, which meant they had to de-lever, meaning, no refi’s – even for solid business with good models. So I shopped around and found an ‘A’ rated bank locally, this new bank, around since 1909, was looking to originate new commercial loans! The reason my new bank was lending when almost all other banks were de-levering, is because they didn’t originate any ‘Liar loans, or undocumented loans, like many others were doing. My new bank has always only lent their own money, which meant they were more selective and diligent in loaning money. They didn’t owe the fed any money when the ‘greed caused crisis’ hit, and they didn’t have to go to the window when things tanked, soooo, they didn’t have to abide by the fed and didn’t need to de-lever their loan portfolio. They gained lots of new business because of their diligence and others failings. Not all banks are created equal. Shop around. Be diligent.

Posted by neversaynever | Report as abusive
 

The changes may be even greater than Mohamed suggests. When printed money becomes the source of government funding, where is the end game? Why have taxes at all?

The need for private capital is the result of individual or collective desire act independently to achieve some task. When “capital” is borrowed from a bank, the true source should be the deferred spending collected by savers, not money printed by government and given to banks.

Yesterday, I visited with a young man who was saving for a dental degree. Our utility just raised rates by 8 percent. I pointed out that his savings just lost 8 percent in value so far as the savings were intend for future utility bills. Very sad. Why save at all when a new government program using printed money could solve the future funding problem?

ThinkEcon

Posted by ThinkEcon | Report as abusive
 

El-Erian only hints at the root cause of the whole collapse of US financial markets, and subsequent fallout in the Eurozone: leverage and derivatives.

Despite Frank-Dodd, despite central banks, and despite rhetoric from the financial gurus, the world financial markets still allow hedge funds and traders to leverage enormous trades, esp. in the FX and Bond market. Couple that leverage (sometime 100 to 1) with derivatives you have the perfect recipe for volatility and crashes.

Anyone who has traded naked options (writing a derivative without holding the underlying) knows how a 5% movement can become a complete wipe-out. That goes on every day in the commodity and FX markets where leverage and derivatives continue to rule those markets.

To bring back stability to banks and the financial markets the central banks along with the various governments need to slap on 1) strict margin levels, such as 80% collateral for all trades including bonds,2) impose 80% tax rates worldwide on all short term trading gains, and 3) levy a 80% tax rate on all derivative income/gains.

Unless the leverage and short term trading is diminished, we will continue on this roller coaster.

Posted by Acetracy | Report as abusive
 

“Look for western banks to be less complex, less global, somewhat less inter-connected and, therefore, less systemic.”

And global trade must go the same way. No more so called free trade blocks. Every nation must produce as much in agriculture and industry as it can, tying producer to consumer, and only the excess trade in FAIR markets.

Posted by Kyung | Report as abusive
 

People are make a mess of the economie. The have a lot of words but don’t come with a good solution for things. They just hold everything in the middle untill things realy fall a part and there is nothing to do anymore. A smart thing to do is to get yourself a backup and build on your own power.

Posted by robertoheckers | Report as abusive
 

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