Saturday, October 11, 2008

The end of the financial world

Lehmann disappeared. Merrill Lynch as well. Morgan Stanley seems to be the next one to disappear. AIG, together with Fannie Mare and Freddie Mac nationalized.
A gigantic rescue attempt of the financial system by the US government spending billions of dollars seems not to stop the anxiety of stocks investors all around the world, all taken by a selling frency. The world of investment banking built up in over a century, nearly disappeared in less than a week.

What’s happening? Is this the end of the world? Actually it is the end of the world, the end of the financial world. What does that mean? Let’s try to understand what is happening.

The service industry always took advantage of its position to get fat and often unjustified margins by its clients. And, within it, the financial industry was the one that got the fattest margins and (probably) the lowest value added for its clients.
In the past bank clients had to book an appointment and meet his/her bank manager to receive good advise and make “good” investments in stocks and bonds.
But this is history. Nowadays you can easily do the same thing over the net with a click of your mouse and without any time wasting. Well, you could argue that the advise of your bank manager is invaluable. But is it?
Over the net you could get such valuable information that, probably, not even a good branch manager of a large bank could give you. And so, whay would you pay so fat margins to your bank? Well, you would say that this phenomenon was already true in the recent past. What does that have to do with Wall Street financial meltdown? In fact it was the sub-prime loan crisis which spurred the meltdown, not the disintermediation and disintegration of the financial industry. True and not.

The sub-prime loan crises accelerated a trend which was already inevitable: the disappeareance of the financial industry the way it is now and the creation of two different financial worlds.
An investment and commercial banking group class which offers standardized products to its clients, and a small group of very high value added institutions which gives real valuable advise to their clients.

The investment banking industry had already undergone a change in the last years but few people had admitted it. The very same change that the commercial banking industry had undergone in the past.
As we might reckon, the standardization of the traditional banking and insurance products made unjustified the fat margins asked by the commercial banks and insurance companies. But, within the financial industry, the investment bank industry was still earning fat margins. The justification was simple: high value-added products offered by very experienced financial experts.
Capital market products (both in bonds, equities and derivatives), advisory on large corporate deals, short-term investments, wealth management and even tax optimization plans: these were most of the sophisticated products offered by the industry and people, corporations, commercial banks and insurance companies were willing to pay large margins to get those products.
But the true was that the products were not that sophisticated and, with the rapid diffusion of information due to the internet, they are easily accessable by most operators today.

In addition the greediness of the investment banking industry made it possible to speculate and make huge bets without the backing of the first and foremost tool of the industrial world: the capital. Regulators set very low capital (BIS) ratios and did not adjust them to the new reality of the financial world of derivatives. With huge leveraged positions made possible with new financial instruments an average trader within a financial firm could bet several times the entire capital of any investment banking group.
In fact what the sub-prime loan crises shows is the replication of Nick Leeson’s lesson at system level: the collapse of the industry due to wrong bets and highly leveraged positions against a relatively low capital base. HBOS case show how a well capitalized bank according to BIS standards in fact was not at all in today’s financial world. What Nick Leeson did at personal level the financial industry did as a system: to bet several times its capital to get high profits in an unsustainable situation of the real estate market. That explains why so many firms collapsed: virtually anyone did it without controls. Leverage against it own capital was absurd and untainable. Once one fell, most of the others came along.

The lack of controls and low capital base just accelerated a clear trend of the financial industry: its uselessness in today’s net world.
Nobody needs the old style financial industry. Neither the average man in the street nor the sophisticated investor nor the large corporations nor the governments.
All we need is a bunch of few institutions where we can deposit our money or get a loan from. And at a cheap rate, the base rate for the industry. But also all the other financial products could be offered as standardized and cheap products by the same institutions. There is virtually no sophisticated financial product not easily accessable at a cheap price anymore. Everything is available and standardized in today’s financial industry. And whoever charges high fees for financial products has his days numbered.
There is room only for a bunch of high value added advisors, capable of putting together sophisticated deals in the capital markets world or people with really true excellent analytical skills to make good investment decisions.
But the crowd of high fliers financial whizz-kids is something of the past. No illusions any more: you must get some real value added for the money today. Gone are the days of “good” advise on some secret deals made in the darkness which would make you rich.
Today nearly everything is standardized in the financial world. And whoever says the opposite might do so to justify his/her untainable margins. But today the financial client knows it and does not buy it anymore.

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