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Just as some species become extinct in nature, some new financing techniques

may prove to be less successful than others.

Assistant Secretary of the Treasury for Financial Markets Anthony W. Ryan before Congress in September 2007

THE

of

Financial Services

Evolution

Making Sense of the Past, Preparing for the Future

by Niall Ferguson and Oliver Wyman

Oliver Wyman is a leading global management consultancy www.oliverwyman.com

COntentS
executive Summary Introduction 1 the consensus view of the industry 2 A century of change in global financial services 3 Of cycles, surges and spasms 4 the role of regulation: Intelligent design? 5 evolutionary lessons in financial services 6 Concluding remarks Bibliography Acknowledgments 9 12 16 28 46 66 75 99 100 105

exeCutIve SuMMAry
The objectives of this report are to test the consensus view of the financial services industry against long-run historical data and to form insights that are based on more than just the last few years. We find that many widely-held views are not safe when considered in the light of several economic cycles. exogenous factors often identified as core engines of finance growth in the early twenty-first century (stable macroeconomic growth, high liquidity and global integration) have been subject to sudden reversal in the past, and cannot be relied upon to continue in the future. At the same time, factors commonly cited as posing near-term threats to the financial services sector (changing demographics and global imbalances) may have acted as growth drivers for the industry. The consensus view also takes for granted continued improvements in technology, risk management and good governance. The historical record, however, suggests that such endogenous sources of growth have not advanced in a linear fashion. Similarly, we question the assumption that there will be inexorable institutional convergence (as best practice spreads) and concentration (because of economies of scale). In contrast, we find a proliferation of forms in the industry and a tendency for institutional diversity to persist. tracing the evolution of financial services over more than a hundred years allows us to set our own times in an unusually broad perspective. A crucial point is that the financial world today is much more like that of the beginning of this period than that of any intervening period. From 1914 to 1980 there were two world wars, multiple revolutions, a Great Depression and a Great Inflation to say nothing of the exclusion of more than half of humanity from the global economic order, thanks to the spread of Communism. During this time liquidity waxed and waned, sometimes with astonishing speed. Demand for financial products grew in aggregate but was highly volatile in individual segments. Financial services were provided by a whole host of different supplier forms that came and went at a remarkably rapid pace. regulatory structures went through major dislocations, frequently in response to unforeseen crises. In this light, it would be highly optimistic to project forward the relative calm of the last decade. The future will not be simply a continuation of the recent past. Indeed, as we have been writing this study, volatility has already returned to financial markets. The long-run view has led us to the intriguing notion that financial services is neither a deterministic nor a wholly stochastic system, but an evolutionary one. When making pragmatic decisions, we do not discern perennial golden rules. nor can we afford to wait for the infrequent appearance of black swans. We do, however, see many similarities to the process of biological evolution, which we believe can explain observed phenomena and by extension provide future guidance.

THE EvoluTion of financial sErvicEs

At any given time, the financial services sector is populated by many different institutional forms competing for resources. As in the natural world, there is persistent (though not random) mutation. As in the natural world, the environment is characterised by punctuated equilibrium: the macroeconomic environment can change spontaneously or the rules can be changed by regulatory intervention. Importantly, extinction is an integral part of the system those kinds of firms that under-perform and fail to adapt ultimately disappear. We do not posit evolution as simply an interesting analogy but as a better framework for understanding industry trends, cycles and events. While there are important differences between biological and financial evolution, three fundamental similarities stand out. First, neither system has a single end-goal looking for this or planning around its assumed shape are futile. Second, no formula works forever todays successes will be tomorrows failures unless they adapt and innovate. Third, mutation is part of the system spontaneous innovation is to be expected and should be encouraged. A new framework also gives us new pointers for the future and offers valuable lessons for those running the industry today. The boards and executive officers of financial services firms would do well to

Keep it natural: growth works best when it is based on real advantage and organic innovation Discard industrial plans: because evolution does not work in neat five-year planning cycles, continuous out-execution (with bold moves where necessary) beats grand strategic designs Make yourself more attractive: winning the competition for talent, capital, customers and other resources is paramount to longevity Worry more about habitats and less about competitors: obsessions with competitors can stunt innovation and miss big waves that lead to habitat loss for all Buy insurance: extreme shocks will almost certainly happen in the future effective risk assessment should lead beyond conventional insurance to the development of re-birth plans

These lessons, emanating from the evolutionary perspective of finance, are quite different from the consensus imperatives of get bigger, diversify, or stick to your knitting. This contrast is even greater when the implications for regulators, supervisors and policy-makers are considered. Intelligent design of the underlying rules of the game seems like the logical role for this privileged group of industry leaders. On closer inspection, however, regulators stand little chance of designing timeless rules for a constantly evolving system.

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We regard this report as the first, rather than the last, word in forming a clearer view of the financial services industry soon to account for 10% of global production. Without such a long-term perspective, current and future industry leaders will struggle to run a critical sector of the economy that in some way underpins most other sectors.

THE EvoluTion of financial sErvicEs

11

IntrODuCtIOn
Few would dispute that the past ten years have witnessed dramatic changes in the financial services sector around the world: deregulation, globalisation, privatisation and securitisation, to name but a few. yet the full magnitude of these changes and their implications for the future can be appreciated only if they are put in a longerterm perspective. In this report, we attempt to take the long view, tracing the major developments in world finance over roughly a century, and casting doubt on what we identify as the consensus view on the future of financial services. Our analysis shows that financial development follows an evolutionary pattern, similar in character to that witnessed in the natural world, though within a much more compressed time frame.1 We believe this has important implications for both financial firms and regulators, at a time when the global macroeconomic environment may be in the early stages of a profound change. It may strike some readers as commonplace that the financial services sector resembles an evolutionary eco-system. Quasi-Darwinian language (only the strong survive) is frequently heard on both Wall Street and Lombard Street. However, previous discussions of financial evolution have tended to be content with superficial analogies based on rather limited understanding of neo-Darwinian thought.2 In fact, the financial services industry has many of the defining characteristics of a true evolutionary system

Genes, in the sense that certain business practices perform the same role as genes in biology, allowing information to be stored in the organisational memory and passed on from individual to individual or from firm to firm when a new firm is created The potential for spontaneous mutation, usually referred to in the economic world as innovation and primarily, though by no means always, technological Competition between individuals within a species for resources, with the outcomes in terms of longevity and proliferation determining which business practices persist A mechanism for natural selection through the market allocation of capital and human resources and the possibility of death in cases of under-performance, i.e. differential survival

The notion that Darwinian processes may be at work in the economy is not new. Thorstein Veblen (188) raised the question and Joseph Schumpeter (143) was sceptical about the applicability of Darwins ideas to the process of economic exchange. The path-breaking contributions were by Alchian (150) and Nelson and Winter (182). Since 11 there has been an entire journal devoted to the subject, The Journal of Evolutionary Economics. The evolutionary model nevertheless remains outside the mainstream of economics, where the neoclassical general equilibrium approach remains dominant See e.g. Kindelberger (184), pp. 85

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Scope for speciation, sustaining bio-diversity through the creation of wholly new species of financial institutions, thereby avoiding the danger that natural selection ultimately produces a world with only one version of the fittest Scope for extinction, with species dying out altogether

Financial history is, in sum, the result of institutional mutation and natural selection. random drift (innovations/mutations that are not promoted by natural selection, but just happen) and flow (innovations/mutations that are caused when, say, American practices are adopted by Chinese banks) play a part. There can also be co-evolution, when different financial species work and adapt together. But market selection is the main driver. Financial organisms are in competition with one another for finite resources (customers, clients, market share). At certain times and in certain places, certain financial species may become dominant. But innovations by competitor species, or the emergence of altogether new species, prevent any permanent hierarchy or monoculture from emerging. Broadly speaking, the law of the survival of the fittest applies. Institutions with a selfish gene that is good at self-replication (and self-perpetuation) will tend to endure and proliferate.3 note that this may not result in the evolution of the perfect organism. A good enough mutation will achieve dominance if it happens in the right place at the right time, because of the sensitivity of the evolutionary process to initial conditions; that is, an initial slim advantage may translate into a prolonged period of dominance, without necessarily being optimal. nevertheless, this process is not wholly endogenous. Periodic exogenous shocks can radically alter the evolutionary environment, rendering certain evolved traits disadvantageous that previously had been advantageous, and vice versa. Financial disruptions (like the Great Depression of the 1930s or the Great Inflation of the 1970s) are like the asteroid strikes and ice ages that periodically intervened in the evolutionary story of life on earth.4 In extreme cases, they can cause mass extinctions of financial species; in milder cases, when environmental change is more gradual or less profound, they eliminate the less fit members. Finally, it is worth bearing in mind that in the natural world, evolution is not progressive, as used to be thought (notably by the followers of Herbert Spencer). Primitive financial life-forms are not condemned to oblivion, any more than the microscopic prokaryotes that still account for the majority of earths species. evolved complexity protects neither an organism nor a firm against extinction the fate of most animal and plant species.

3 4

Dawkins (18) Gould (18)

THE EvoluTion of financial sErvicEs

13

The analogy is, admittedly, not perfect. Firms are not quite the same as biological organisms. When one organism ingests another in the natural world, it is just eating, whereas in the world of financial services, mergers and acquisitions can lead directly to mutation. In financial organisms, there is no counterpart to the role of sexual reproduction in the animal world (though demotic sexual language is often used to describe certain kinds of financial transaction). In financial organisms, most mutation is deliberate, conscious innovation, rather than random change. Indeed, because a firm can adapt within its own lifetime to change going on around it, financial evolution (like cultural evolution) may be more Lamarckian than Darwinian in character. And in the natural world there are no regulators or governments. Still, the following summary of evolutionary theory by an eminent biologist is at least suggestive that the resemblances outnumber the differences. The ultimate purpose in life [is] to be better than your neighbour at getting genes into future generations, in which those successful genes provide the message that instructs the development of the next generation, in which that message is always exploit your environment, including your friends and relatives, so as to maximise our genes success, in which the closest thing to a golden rule is dont cheat, unless it is likely to provide a net benefit. taking the long view, we can discern some of the most important trends in the evolution of financial services, and identify possible future developments as both natural selection and intermittent shocks exert their influence on the population and forms of financial institutions. The conventional view of financial development tends to see the process from the vantage point of the successful survivor firm. In the firms official family tree, numerous small firms are seen to converge over time on a common trunk, the present-day conglomerate. However, this is precisely the wrong way to think about financial evolution. Over the long run, financial innovation begins at a common trunk. Over time, the trunk branches outwards as new kinds of banks and other financial institutions evolve. The fact that a particular firm successfully devours smaller firms along the way is more or less irrelevant. In the evolutionary process, animals eat one another, but that is not the driving force behind evolutionary mutation and the emergence of new species and sub-species.

George C. Williams, quoted in Dawkins (2003), p. 8.

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The implication is that economies of scale and scope are not always the driving force in financial history. More often, the real drivers are the process of speciation whereby entirely new types of firms are created and the equally recurrent process of creative destruction whereby weaker firms die out or, more commonly, get eaten. These processes are often accelerated in times of economic disruption. regulators must be careful not to impede them out of a misguided sense that established firms are all too big to fail.

THE EvoluTion of financial sErvicEs

15

We begin by summarising what we see as the prevailing consensus on the state of the financial services industry the view held by most investors, analysts, regulators, managers and media observers based on trends of the past decade. For the most part, the sector is thriving in a benign global economic environment. For the past 10 years, the world economy has been growing at an average annual rate of ~4% p.a. and keeping unemployment levels below 10% in most developed countries. Wealth creation and economic liberalisation the two fundamental drivers of financial services growth have been sustained and are spreading among international economies. There are, admittedly, several potential threats to this benign environment, such as the ageing of the population, global imbalances (notably the uS current account deficit), bubbles in emerging economies, continuing volatility in credit markets, climate change, and the threat of terrorism. But these seem too remote, too uncertain, or too limited in scale to have a profound impact on the provision and consumption of financial services in the decade ahead. At the same time, regulators, policy makers, and competition authorities are, by historical standards, doing a good job of protecting consumers and maintaining financial stability. While the cost of regulation relative to the size of the industry is increasing, the benefits of supervision (such as fewer bank failures) are becoming more tangible; the fiscal and monetary policy mix has also contributed to a marked reduction in macroeconomic volatility. The principal threat to the sector may come not from excessive regulation but from innovations (for example in the derivatives market) beyond the control of established monetary and regulatory authorities. under these conditions, according to the conventional view, it is no surprise that the financial services sector has attained new peaks

tHe COnSenSuS vIeW OF tHe InDuStry

total industry value is ~$6 tn, up 60% over the last ten years total revenues are ~$2.7 tn, accounting for 7% of global GDP and rising return on capital is the highest ever: 20% at year end 20066 employment in the sector is at its highest level ever Loss rates are still below cyclical averages, despite recent write-downs arising from the sub-prime mortgage defaults and the credit crunch in the market for collateralised debt obligations and other asset-backed securities
Unity in Adversity, The Economist, September 6, 2007

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Banks, insurers, asset managers, and other providers of financial services have become better at innovation, marketing, production, risk management, and governance. Customers (be they individuals, corporations, or public enterprises) have an unprecedented choice of financial products and providers. More important, they have better ways of determining which products and services are best for them, not least because of the spread of transparency through the Internet. The consensus view is that the financial services sector is about to progress from one golden decade to another, despite occasional and inevitable business cycle setbacks. In figure 1, we have integrated multiple quantitative and qualitative views to create a picture of financial services growth over the past decade, which projects revenue growth of 77% in combined global financial services revenues between now and 2017.
1. GlobAl fiNANCiAl SerViCeS reVeNUeS for The lAST AND NexT DeCADe
4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

North America

Europe

Asia Pacic

Latin America

Rest of World

Source: oliver Wyman, The future of financial Services (2005)

Such an optimistic consensus view seems to be predicated on the continuation of several key trends. Some are positive, others are negative, but overall the outlook is highly optimistic.

THE EvoluTion of financial sErvicEs

17

2017

A SUpporTiVe mACroeCoNomiC poliCy CoNTexT An important factor in the recent period of sustained growth and low inflation (see figure 2) is that the world is currently enjoying (in the words of The Economist) an unusually benign economic climate7 and relative political stability. Political unrest and conflict have been minimal in europe, the Americas, and large parts of Asia. Only Sub-Saharan Africa, parts of the Middle east, and a handful of other failed states (e.g. Haiti) are still crippled by internal instability. Although progress has slowed in the World trade Organizations Doha round, there has been no significant upturn in protectionism. trade in goods and services has continued to grow, with exports still the key driver of growth in Asia. Capital controls have become the exception rather than the rule. restrictions on immigration have not prevented unprecedented integration of the global labour market, with measurable impacts on service sector labour costs and on manufacturing. At the same time, there have been significant improvements at the national level in both fiscal and monetary policy. Fiscal deficits have not been eliminated, but they have generally been kept below the 5% of GDP threshold, and financed in a noninflationary way (through bond sales). Monetary authorities, having largely won the battle against high inflation in the 1980s, have adopted a variety of different approaches with the common objectives of price stability (a consumer price inflation rate of below 3%) and sustainable growth (a growth rate that does not exceed or undershoot productive capacity). to prevent a repeat of the Asian crisis of 1997-8, Asian central banks have adopted more or less pegged exchange rates and accumulated very large foreign exchange reserves. Their huge accumulations of dollars and dollar-denominated bonds have tended to depress long-term interest rates in the united States, which might otherwise have risen further as a result of the deficits due to the 2001-2 recession, the Bush administrations tax cuts and its lavish expenditure at home and abroad. Here, too, the consensus view is of a benign global environment for financial services. Perhaps the most heartening news of all, in this mainstream view, is the recent and projected growth of the biggest emerging economies Brazil, russia, India, and China as well as the many smaller countries benefiting from economic openness. In China, a fifth of humanity is on the march. With an average rate of real per capita GDP growth of 8.4% since 1978, the Chinese economy has increased in size by a factor of ten. According to calculations by Goldman Sachs, the ratio of uS per capita income to Chinas per capita income is now approximately 23 to 1. By 2050, however, the ratio could be less than 3 to 1. This implies an extraordinarily rapid convergence.

The Alchemists of finance, The Economist, may 17, 2007

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2. GlobAl GDp GroWTh, iNflATioN rATeS AND iNTereST rATeS


% 30 25 20 15 10 5 0 -5 1981 1991 1999 2001 -10 1970 1972 1974 1976 1978 2003 1983 1985 1987 1989 1993 1995 1997 2005

GDP growth

Ination rate

Interest rate

Source: mitchell (2003), oeCD, oliver Wyman analysis

hiGh liqUiDiTy, effiCieNCy AND GlobAl iNTeGrATioN Though the recent crunch has reduced the availability of credit in many markets, liquidity is still high. The availability of capital has allowed even forced investors to diversify their holdings into increasingly exotic asset classes (such as special situations, distressed debt, art, and wine) which, along with traditional assets, enjoyed a long and largely uninterrupted bull run from 2003 until the summer of 2007. The recent efforts of some central banks to try to avert a credit crunch have only increased liquidity. Some worry that excessive liquidity could fuel either consumer price inflation or bubbles in one or more asset classes. But most market participants plainly prefer excessive liquidity to a credit crunch. In addition to being more liquid than ever, capital markets are also widely believed to be more efficient now than at any point in history, and globally integrated as never before. Frictional costs involved with transferring capital from one financial instrument to another are at an all-time low. Increased efficiency in the capital markets, aided by improvements in technology and greater competition between exchanges, has lowered transaction costs and made the movement of capital freer than at any point in history. Capital flows freely across borders and limits to foreign ownership are being relaxed throughout the developed (if not the developing) world. regulatory barriers to capital movement and ownership have been removed to the extent that, within the developed world, cross-border ownership of assets of most traditional kinds has become very common. For precisely this reason, some countries (mainly in the english-speaking and Mediterranean worlds) have been able to maintain large current account deficits, supported by foreign governments and investors. Financial institutions from developed economies are reinforcing this trend by seeking new revenue opportunities in

THE EvoluTion of financial sErvicEs

1

developing countries (setting up subsidiaries or engaging in joint ventures outside their own mature, low-growth markets) while developing economies invest in highly rated securities originating in more mature financial markets. The DemoGrAphiC CoNTexT Although the global macroeconomic environment seems generally favourable, conventional wisdom holds that demographic changes are likely to create financial problems, particularly in developed nations. As the post-war baby boom generation of the developed world begins to retire, dependency rates are set to rise. The proportion of the uS, european, and Japanese population aged 65 and over is expected to increase from 20% today to more than 36% by 2050 (see figure 3). Most analysts expect this trend to have major financial consequences. retirementrelated assets are expected to reach $25 tn by 2010.8 Investment demand will shift from stocks to bonds, the popularity of annuities will rise, and the deficits of the worlds defined-benefit pension funds will be exposed. Governments will likely have to bail out under-funded pension systems, while the working-age population will see their tax burdens rise to pay for the growing number of dependents. All this may create opportunities for those financial institutions that are able to adapt quickly to the new social order. Wealthy retirees are likely to require new products and services, and are likely to be more financially sophisticated than in the past. nevertheless, most commentators expect these demographic changes to have a negative impact on financial services as a whole.

Deloitte (2007)

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3. eSTimATeD AGe DiSTribUTioN of US, eUropeAN, AND JApANeSe popUlATioN 2000-2050


100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

<14
Source: United Nations

15-64

>65

GlobAl imbAlANCeS The conventional wisdom also has it that the biggest short-run threat to financial stability arises from global imbalances: the current account deficits of the uS, other Anglosphere and Mediterranean countries, and their mirror image, the surpluses of Asian emerging markets and energy-exporting countries. The current account surplus of China is now around $200 Bn, while the countrys foreign exchange reserves stand at well over $1 tn larger than estimations of even the biggest sovereign wealth funds (see figure 4). Although this state of affairs is sometimes referred to as a stable disequilibrium, it is not hard to see how it could become unstable. A major realignment of the Chinese currency (estimated to be undervalued by as much as 50%)9 would sharply increase the cost of imported manufactures to the developed world. Similarly, any downturn in the uS economy would have repercussions around the world. It is important to recall that about 20-25% of Chinas GDP depends directly on trade with the uS, which accounts for a fifth of Chinese exports.

Dunaway, and li, (2005)

THE EvoluTion of financial sErvicEs

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2050

4. ChiNeSe bAlANCe of pAymeNTS AND foreiGN exChANGe reSerVeS


$TN 1.0 $BN
200 150 100

0.5
50 -0

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Foreign exchange reserves


Source: SAfe China

Current accound balance

Summing up the conventional wisdom, then, the global macroeconomic environment is exceptionally benign from the point of view of financial services. Liquidity remains abundant, despite the credit crunch of August-September 2007. true, demographic trends and global imbalances are worrisome. But the overall outlook is rosy. How are financial institutions likely to evolve under these circumstances? The consensus view foresees a continuation of the following trends. CoNTiNUeD rApiD iNNoVATioN AND iNVeSTmeNT iN TeChNoloGy In recent years, hedge funds and investment banks have found ever more inventive ways to generate returns and structure financial instruments, generating enormous income and wealth in the process. At the same time, simple products have become increasingly commoditised, with firms ever more focused on selling high volumes at low margin. Financial institutions spending on and use of information technology is likely to continue to increase as companies seek to achieve greater productivity. Improving the volume and speed of communication drives competitive advantage in an industry in which information transfer is crucial. Partly because of technological innovation, the financial services sector is tending to overlap more and more with other industries such as energy, real estate, and healthcare. retailers are venturing into consumer finance and retail banking, while some utilities are starting to trade financial instruments. Industrial companies are holding increasing volumes of interest rate and foreign exchange derivatives, mostly to mitigate the various risks of doing business. non-financial institutions are also increasingly offering

22

2006

0.0

-50

financial services. volkswagen has become one of Germanys fastest growing financial institutions by financing private used car sales. uK retailer tesco is now in insurance, and WalMart has entered retail banking in Mexico. At the same time, there is some evidence of speciation within the financial services sector, as new niche markets emerge. Islamic banking, takaful insurance, socially responsible investing, and community banking are all notable areas of growth. As these niches grow, some are likely to cluster around their natural geographical hubs the Middle east or South-east Asia for Islamic banking and insurance, for example. improVemeNTS iN riSK mANAGemeNT The consensus view is that aided by regulation and innovative financial products, financial institutions have raised their risk management techniques to a level of sophistication and effectiveness never seen before. For example, firms are now using derivatives and other tools to diversify balance sheet risk through the purchase of credit default swaps (CDS). As figure 5 shows, outstanding CDSs have grown from next to nothing 10 years ago to more than $20 tn today. Firms are seeking to remove risk from the balance sheet altogether through the sale of repackaged assets such as mortgage-backed securities (MBS) and asset-backed securities (ABS). new entities like conduits and Structured Investment vehicles (SIvs) have emerged, whose primary purpose is to trade these instruments. While regulatory demands are a burden to financial institutions, new techniques and instruments have allowed banks to lower their risk profiles significantly. recent turbulence in the credit markets and attendant doubts regarding the accuracy of credit ratings are likely to slow progress in this direction, but not to reverse it.
5. GroWTh of GlobAl CDS mArKeT
$TN 25 20 15 10 5 0

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Source: bbA

THE EvoluTion of financial sErvicEs

2006

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Financial innovation is happening at a remarkable pace, as traditional balance sheet banking declines in significance. The booming markets for secondary securities such as corporate mortgage backed securities (CMBS) and retail mortgage backed securities (rMBS see figure 6) are testament to this decline. Combined issuance of ABS and MBS has grown from nothing in the mid 1980s to over $3 tn annually. Indeed, packaging and removing risk from the balance sheet is increasingly being seen as the most important skill in banking. While gathering assets in the form of deposits is still important, originating loans and holding them on the balance sheet is no longer considered the way to run a successful bank.
6. GroWTh of GlobAl AbS AND mbS iSSUANCe
$BN 3,000 2,500 2,000 1,500 1,000 500 0

1980

1982

1984

1988

1990

1992

1994

1996

1998

2000

2002

1986

2004

MBS
Source: Thomson financial, federal reserve bank of New york

ABS

traditional securities exchanges are declining in significance and are expected to decline in number. electronic exchanges are taking their place, and over-the-counter (OtC) sales of complex financial instruments are increasingly common. In response to these pressures, exchanges are consolidating, seeking strength through greater volumes of business and by forging complementary partnerships both regionally and globally. The exchange of tomorrow is likely to be an entirely virtual entity, replacing the bricks and mortar exchanges of the past.

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2006

GoVerNANCe AND iNSTiTUTioNAl formS until recently, it was widely believed that the long-term trend in financial services was for consolidation and the emergence of an ever-smaller number of ever-larger firms a tendency symbolised by the creation of Citigroup, HSBC, and other large multibusiness, multi-geography providers. This long-term trend towards concentration seemed to follow the logic of economies of scale and scope, as experienced by other mature industrial sectors of the economy in the twentieth century. A recent change in sentiment seems to be driven by scepticism about cross-border ownership structures and the risks hidden in highly complex, diverse organisations. This new, more nuanced view sees further industry-wide consolidation (especially in countries where finance is fragmented, such as the uS, Germany, and Italy) but emphasises industrial logic as well as sheer size. Another recent development is the increased degree of activism within the financial services shareholder base. The rise of private equity partnerships, hedge funds, and other professional investors (e.g., insurance companies, pension and mutual fund managers) has created a much more knowledgeable and active shareholder base. The consensus view is that publicly quoted financial corporations will increasingly be influenced, both directly and indirectly, by activist investors. The recent experiences of Deutsche Brse, the London Stock exchange, and other entities identified as targets by private equity acquirers are testament to the rising activism of the sophisticated shareholder. SUperViSioN AND reGUlATioN Another threat identified by most commentators is cumbersome regulation. SarbanesOxley, Basel II, Solvency II, MiFID, and IFrS are likely to increase costs for financial services companies by forcing them to enlarge their legal, accounting, and compliance divisions. regulations are likely to become even more burdensome in the areas of privacy, security, partnership, and operational risk, since nearly all the new regimes push for higher standards of transparency, accountability, and corporate governance. Compliance failure brings its own new risks, so additional regulations paradoxically can make the world a more risky place for financial services companies, even if their net effect is to increase systemic stability.

THE EvoluTion of of financial sErvicEs THE EvoluTion financial sErvicEs

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oVerVieW In this chapter, we have identified a number of themes which define the conventional wisdom on the financial services sector, based on experiences of the past decade

At the international and national level, trade, fiscal and monetary policy offer a benign combination of liberalisation, counter-cyclical stabilisation, and low inflation that is not about to disappear very high levels of liquidity will continue, as will high levels of global integration and capital market efficiency Demographic trends will move a large proportion of the population into retirement, which may create shifting and unpredictable demands for financial products Global imbalances will persist, which could lead to potential instability if, for example, Chinas currency were to appreciate sharply

The outlook for the sector is also somewhat ambivalent, though again on balance positive

High rates of innovation and improvements in technology will continue Sophisticated risk management and transfer techniques will continue to marginalise traditional banks and exchanges Shareholder activism will also increase, imposing changes in the governance and ownership structures of financial services organisations Supervision and regulation will continue to impose costs as well as systemic benefits

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From the perspective of different industry stakeholders, this is how the conventional wisdom looks:
Consumer

Employee

Investor

increased complexity of offering proliferating product ranges increasing technological sophistication

Size of employer as a company growing increasing specialisation and complexity of roles within organisations increasing outsourcing abroad

high degree of cyclicality in fS stocks as investments increasing m&A activity increasing private equity activity and activism

Manager

Regulator

Service provider

pay more frequently performance-linked Competition as fierce now as ever regulations increasingly burdensome

industry moving more and more towards risk-based frameworks Stability and diversification are the most important trends, though capital markets are moving the sector into the unknown

increasing complexity of operations and systems one of the largest customer segments (especially for technology)

It seems to us that the answers to most of the challenges now facing financial services are broadly couched in terms of product design and distribution, regulation, management and incentive structures. It is widely assumed that best practice is being rolled out globally in all areas of the industry.

THE EvoluTion of financial sErvicEs

27

The consensus view is largely based on extrapolation of trends from the past decade. Thinking in terms of evolutionary patterns, however, forces us to take a longer view. If we expand our horizons to consider the past century, we see that

A Century OF CHAnGe In GLOBAL FInAnCIAL ServICeS

economic stability and global integration have varied enormously Liquidity has fluctuated widely Global integration has been reversed more than once Financial systems have been faced with high dependency ratios before now Global imbalances are less of a novelty and perhaps less of a hazard than a short-term perspective might lead us to assume

eCoNomiC GroWTh AND iNflATioN Though the past decade has seen economic stability, the norm in recent history has been instability. The twentieth century has seen extreme economic instability, with significant variations in the growth rate, inflation, and unemployment. The average rate of inflation was 0.6% from 1870 to 1914, 8.5% from 1914 to 1945, and 6.6% from 1945 to 1989. Only since 1990 has inflation settled to an average rate of 1.1%. nominal GDP growth from 1870 to 1914 averaged 2.5%, 5.3% from 1914 to 1945, and 8.6% from 1945 to 1989. Since 1990, GDP growth has averaged 4.9% (see figure 7).

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7. mACroeCoNomiC iNSTAbiliTy iN The TWeNTieTh CeNTUry


70% 60% 50% 40% 30% 20% 10% 0 -10% -20% -30% 1870 1878 1886 1894 1902 1910 1918 1926 1934 1942 1950 1958 1966 19741982 1990 1998 2006 Nominal GDP Growth Ination rate

Source: mitchell (2003), liesner (18), US Census bureau, UK National Statistics, United Nations. Countries included are US, Japan, UK, Spain, italy, Germany, france and Switzerland

From 1880 to 1914, the standard deviations of GDP growth and the inflation rate were 3.7 and 3.4 respectively. From 1914 to 1945, volatility was very high at 6.8 and 7.7, and neither measure passed below 1880-1914 levels until 1956. Since 1994, volatility has been much lower than historic rates, at 2.0 and 1.2 on average (see figures 8 and 9).

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2

8. GDp VolATiliTy iN The TWeNTieTh CeNTUry


40% 35% 30% 25% 20% 15% 10% 5% 1908 1915 1922 1929 1936 1943 1950 1957 1964 1971 1978 1985 1992 1999
1994

1880

1887

1894

France US Finland

1901

UK Switzerland

Germany Austria Norway

Japan Belgium

Italy

Spain Denmark

Netherlands

Sweden

Source: mitchell (2003), oeCD, US bureau of economic Analysis, Carter, Gartner, haines, olmstead, Sutch and Wright (2006), oliver Wyman analysis. Calculated by taking a rolling standard deviation of the past five years of GDp growth. french and German time series have time series gaps during war time

. iNflATioN VolATiliTy iN The TWeNTieTh CeNTUry


50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 1880 1886 1892 1898 1904 1910 1916 1922 1928 1934 1940 1946 1952 1958 1964 1970 1976 1982 1988 2000 2006 0%

France Switzerland Finland

UK US Netherlands

Japan Austria

Germany Belgium

Italy

Spain Denmark Portugal

Norway

Sweden

Source: mitchell (2003), oeCD, oliver Wyman analysis. Calculated by taking a rolling standard deviation of the past five years of inflation rates

30

2006

0%

It is also worth noting the extent of regional variation in long-term economic performance. It is widely assumed today that Asian emerging markets will continue to narrow the gap between themselves and the developed economies. One hundred and thirty years ago, a similar forecast might have been made with respect to Japan (see figure 10). In 1874, Britains per capita GDP was approximately 4.4 times higher than Japans. By 1940, the ratio was down to 2.2:1. yet the disruptive effects of the Second World War set Japan back almost to square one. It was not until the 1960s that convergence returned to its long-run trend-line. There is an important lesson here for those who make projections in the form of smooth lines.

THE EvoluTion of financial sErvicEs

31

10. briTiSh/JApANeSe (1874-18) AND US/ChiNeSe per CApiTA GDp (2000-2050)


British/Japanese GDP per capita
5 4 3 2 1 0

1874

1880

1886

1892

1898

1904

1910

1916

1922

1928

1934

1940

1946

1952

1958

1964

1970

1976

1982

US/China GDP per capita


45 40 35 30 25 20 15 10 5 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 0

Source: maddison, A, (2003)

liqUiDiTy AND GlobAl iNTeGrATioN As we have seen, liquidity is generally agreed to be at a very high level today. But what exactly do we mean by liquidity? Liquidity has been defined in different ways at different times, and a lack of liquidity during a crisis rarely means the same thing twice. We consider liquidity to consist of three measures

Cash, deposits, and money market instruments measured by Marshallian K: the money supply as measured by the monetary aggregates M1, M2, and M3, divided by nominal GDP

32

1988

1994

real and nominal interest rates where a lower interest rate implies cheaper money and hence higher liquidity, this being the main measure by which liquidity fell during the summer of 2007 trading activity in markets for financial assets in terms of volumes traded and bid-ask spreads

Over a century, it is relatively easy to use Marshallian K. By calculating Marshallian K for all of those markets where data are available, we are able to show that liquidity is not currently exceptionally high compared to the last hundred years. to be sure, the measure produces some counterintuitive results. The wartime and Great Depression periods appeared to experience extremely high liquidity, but this was primarily due to decreased GDP during these periods. even when we exclude these periods, we find that liquidity is still not exceptionally high by historical standards in terms of a narrow monetary measure. Measured using M1, Marshallian K today (0.33) is only just above the 1914 level (0.28). Broader monetary measures, however, do confirm the high liquidity hypothesis. Calculated using M2, Marshallian K was 0.49 in 1914, a level equalled at the end of the Second World War, and currently stands at 0.66 (see figure 11). M3, the measure that includes the largest quantity of financial instruments, has only been tracked over the past 50 years. M3 Marshallian K starts at 0.61 in 1960, rising to 1.07 today. Measured on this basis, liquidity is evidently significantly higher than it used to be.

THE EvoluTion of financial sErvicEs

33

11. mArShAlliAN K (liqUiDiTy) iN DeVelopeD CoUNTrieS


M1, M2 and M3 divided by nominal GDP (weighted global average) 1.1 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 1975 1980 1985 1990 1995 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 2000 2005 0.1

M1

M2

M3

Source: bank of england, Datastream, mitchell (2003), Swiss National bank, Carter, Gartner, haines, olmstead, Sutch and Wright (2006), oliver Wyman analysis

The relatively smooth curves of Marshallian K, however, hide numerous crises that have arisen over the past century and a half. As shown in Box 1, such crises, sometimes triggered by small events, have the capacity to rapidly suck out liquidity from the system.

34

box 1 A brief hiSTory of CriSeS, CrASheS AND pANiCS The following is a brief summary of the triggers and responses to crises in the uS financial markets over the last 150 years.
Trigger banking firm Jay Cooke & Co. files for bankruptcy after overinvesting in railroads run on gold supply means that people can no longer exchange silver notes, causing silver price to drop Sequence of events

Regulatory reaction

Loss of confidence in president Grant and Congress leaders of banking and manufacturing

Panic of 1873

The New york Stock exchange closes for 10 days 18,000 businesses fail between 1873 and 1875, 8 of the countrys 364 railroads eventually go bankrupt Unemployment reaches 14% by 1876 prices of other commodities drop financial trusts collapse and Wall Street comes close to crashing as industrial stocks are hardest hit and railroads go broke european banks sell their American securities resulting in bank run and the closure of 500 banks and 15,000 companies heinzes butte Savings bank fails reports associate the Knickerbocker Trust Company with heinze which closes after suffering a run, paying out $8 mm over 3 hours Trust Company of Americas reputation similarly damaged by association and barely survives a run; Stock market narrowly avoids a crash finances also hit by european investors reluctant to buy the citys bonds

1873-1876

Treasury injects $26 mm into economy

Sherman purchase Act was repealed Treasury no longer forced to buy silver with notes redeemable for silver or gold

Panic of 1893

president Cleveland and the Democratic party

183-186

Panic of 1907

14-30 october

Speculator f.A. heinze tries to corner the stock of United Copper Company which then collapses, losing $50 mm

Treasury deposits $25 mm in New york City Trust Jp morgan pressures trust company presidents and bankers into putting up funds to support ailing trusts

Associates and associated institutions of f.A. heinze

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35

Trigger black Thursday (stock market crash)

Sequence of events

Regulatory reaction

Loss of confidence in banks, governments, and regulators

exchange falls 12% on Tuesday Smoot-hawley trade bill is passed in June 130 GNp falls by 31% while unemployment rises to 24% industrial stocks down 80%; 10,000 banks fail Third bank panic occurs in march 133 and a bank holiday is declared to avert a run on banks roosevelt announces plans to redistribute wealth from rich to poor 13, Depression ends worldwide as countries prepare for World War ii opeC announces a 25% cut in output and threatens a further 5% price per barrel quadruples, gasoline prices double, and NySe shares lose $7 bN in 6 weeks Sudden inflation and economic recession hit industrialised countries such as france and US, causing unemployment energy shortages cause the closure of schools and more factories embargo is extended to portugal, rhodesia, and South Africa Wednesday 14: Trade deficit report pushes dollar down. Tax announcement and rise in interest rates put further pressure on equity prices monday 1: futures open on time with heavy selling. DJiA and S&p 500 drop 23%. S&p 500 futures fall 2%. rumours of exchange closure spark more sales. high volume overwhelms system and trades are reported late Tuesday 20: fed announces it will support financial system, lifting market sentiment, but prevents arbitrage traders from using DoT system to trade. portfolio insurers sell in futures market, pushing down prices. index arbitragers not active, unable to mitigate pressure in the futures market

fed cuts the interest rate from 6% to 4% Tax raised from 25% to 63% Congress passes the emergency banking bill, the Glass-Steagall Act of 133, and other legislation

Great Depression 12-13

1973 oil crisis october 173-march 174

opeC announces embargo on petroleum exports to countries supporting israel in its conflict with Syria and egypt

president Nixon signs the emergency petroleum Allocation Act Western nations central banks cut interest rates to encourage growth, but stagflation results embargo lifted march 174

National energy security

US house of representatives files legislation to eliminate tax benefits for m&As Black Monday 1987 1-20 october US trade deficit for August is above expectations

fed lowers interest rates and injects liquidity fed helps banks extend credit to securities firms, liberalises lending of securities and steps up supervisory efforts Circuit breakers introduced

Use of computers in stock markets to engage in arbitrage and portfolio insurance strategies

36

Trigger may 14: Thailand spends billions of dollars of its foreign reserves to defend the baht against speculative attacks

Sequence of events

Regulatory reaction

Loss of confidence in The imf The governing parties in Asia and russia

Thai baht hit by speculation. Currency crisis spreads through Southeast Asia. Currencies come under pressure, and governments and central banks resort to imf aid packages. hong Kong raises rates to 300% to protect the hK Dollar. Chinese, Japanese, and Korean currencies come under pressure russian markets affected: Central bank triples interest rates to protect ruble; stocks and bonds soar after the imf announces a $23bN emergency loan package for russia, but collapses when russia officially defaults on debts Dow loses 300 points in thirdbiggest loss and falls a further 512 points following turmoil in russia. fed cuts interest rates 3 times in 7 weeks before Dow rallies. Consortium of US financial institutions provides a $3.5bN bail-out to lTCm, fearing collapse could worsen panic. Stocks fall in europe latin American stock and bond markets plunge on fears of default and devaluation in South America and global crisis. brazil sees half of its market value erased, while mexico is forced to defend its currency multi-billion dollar sell orders for major high tech stocks (Cisco, ibm, Dell etc) are processed simultaneously, triggering chain reaction of selling. NASDAq loses % in 3 days, falling from 5050 on march 10 to 4580 on march 15 2001, bubbles deflation running full speed. majority of the dot-coms cease trading after using up their venture capital, often without making a net profit

Substantial imf bailouts given to affected Asian nations conditional on a series of reforms Central banks across the world intervene to defend their currencies enhanced surveillance by imf and increased focus on prevention of crises introduction of international codes and standards to improve reporting and transparency

Asian crisis 1997 17-1

Dot com bubble burst 2001-2003

NASDAq peaks at 5,048.62 on march 10

improvements in the Chinese Wall concept arising from conflicts of interest

equity analysts, for publishing allegedly dishonest analysis on firms

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37

Trigger Defaults on sub-prime mortgages following drop in house prices

Sequence of events

Regulatory reaction

Loss of confidence in Credit rating agencies, who are criticised for not spotting companies with credit problems, and also debt bundles involving sub-prime mortgages

Defaulting sub-prime mortgages collapse CDos. hedge funds report massive losses: Two funds run by bear Stearns lose all of their $20 bN value. house prices collapse and short-term credit markets Worries about the sub-prime crisis and fears about how many financial firms are exposed to these problems hit global stocks in US, london, france, and Germany. markets remain jittery as further reports emerge concerning significantly reduced thirdquarter profits and bail-outs of financial institutions The european Central bank (eCb) is forced to inject $5 bN euros into the euro banking market to allay fears about a credit crunch, while the fed and the bank of Japan take similar steps

eCb loans $130 bN to assuage the credit crunch. fed and Japans central bank resort to similar means The bank of england resists but eventually falls into line The fed cuts fund rates by half a percentage point investment banks pump money into funds to shore up value

Credit crunch 2007-

38

There are, however, other ways of measuring liquidity. Put in the simplest terms, liquidity means the abundance of money. When money is abundant, we would expect that the price of money (the interest rate) would be low. As figure 12 shows, if we take interest rates as a proxy for liquidity over the last hundred years, we find that the levels of liquidity we are witnessing today are by no means extreme. Average real and nominal interest rates were 4.3% and 4.6% prior to 1914, diverging to -1.0% and 5.1% between 1914 and 1989. Since 1989, the averages have been 3.6% and 4.9%.
12. reAl AND NomiNAl iNTereST rATeS iN DeVelopeD CoUNTrieS
15% 10% 5% 0% -5% -10% -15% 30% 20% 10% 0% -10% -20% -30%

1870

1878

1886

1894

1902

1910

1918

1926

1934

1942

1950

1958

1966

1974

1982

1990

Nominal (left hand side)

Real (right hand side)

Source: bank of england, United Nations, Nber, Global financial Data. Data is for Japan, UK, france, Germany and italy, plus Switzerland, the US and Spain and from 107, 114 and 153 respectively

In view of the different definitions of liquidity, we would ideally combine them all into a composite measure of liquidity: a weighted combination of all the liquidity-related factors tracked for this study (including bid-ask spreads and market capitalisations for the years when data are available). This measure (see figure 13) shows liquidity rising during the late nineteenth century, falling and then rising again during the Great Depression and the Second World War a time when monetary expansion associated with reflationary policies and war finance outpaced growth. Our proprietary liquidity index tended to decline from the end of the Second World War until the period of financial liberalisation in the 1980s and 1990s.10 up until 2000, liquidity was similar to that on the eve of the First World War. Only in the last few years has it risen above that level.

10 The oliver Wyman liquidity variable consists of a weighted combination of real and nominal interest rates, marshallian K on m1 and m2 and the market capitalisation of world stock and bond markets. Source: mitchell (2000), oeCD Statistics Dept, UN Statistics Dept, Datastream, World federation of exchanges

1998

2006

THE EvoluTion of of financial sErvicEs THE EvoluTion financial sErvicEs

3

13. oliVer WymAN liqUiDiTy VAriAble for SeleCT eCoNomieS


Global liquidity 100 90 80 70 60 50 40 30 20 10 1921 1900 1907 1914 1928 1935 1942 1949 1956 1963 1970 1977 1984 1991 1998 2005 0

Source: mitchell (2003), oeCD Statistics Dept, United Nations, Datastream, World federation of exchanges, oliver Wyman analysis

Similarly, we would do well not to exaggerate the novelty of contemporary levels of globalisation. The last age of globalization (from the 1870s to 1914) was similar to our own in at least five ways. First, it was characterized by relatively free trade, limited restrictions on migration and hardly any regulation of capital flows. Second, inflation was low and growth relatively stable. Third, there was a wave of technological innovation that revolutionized the communications and energy sectors; among other things, the world discovered the joys of cables, wirelesses, the internal combustion engine and tarmac. Fourth, the American economy was the biggest in the world and the development of its massive internal market became the principal source of business innovation. Fifth, China was opening up, raising all kinds of expectations in the West. russia was growing rapidly too. But after 1914 world markets were disrupted and disconnected, first by economic warfare, then by post-war protectionism. Prices went haywire indeed, a number of major economies suffered both hyperinflation and steep deflation in the space of a decade. Although technological and managerial innovation did not stop, the American economy ceased to be the most dynamic in the world; it faltered during the war, overheated in the 1920s and languished throughout the 1930s in the doldrums of depression. China succumbed to civil war and foreign invasion, defaulting on its debts and disappointing Sino-optimists in the West. russia suffered revolution, civil war, tyranny and foreign invasion. Both these giants responded to the mid-century crisis by donning the constricting armour of state socialism. In this they were not alone.

40

Periods of hyperinflation, now unheard of in the developed world hit several european economies during the early twentieth century. Germany suffered two complete currency collapses within less than thirty years. By the end of the 1940s nearly every government in the world, including those that retained political freedoms, imposed restrictions on trade, migration and investment as a matter of course. Some achieved autarky, the ideal of a de-globalized world. Consciously or unconsciously, all were applying in peacetime the economic restrictions that had first been imposed between 1914 and 1918. Only slowly after 1945 were these distortions removed. trade was liberalized well ahead of capital movements; under the Bretton Woods system, most countries retained capital and exchange controls. Banking systems were tightly regulated, where they were not directly state-owned. It was not until after the Great Inflation of the 1970s that the environment became more benign for financial services, beginning with the breakdown of fixed exchange rates and the deregulation of the British and American financial systems in the 1980s and 1990s. It is true that there have been great advances in trade liberalization since the 1940s. As a proportion of GDP, however, trade has not reached unprecedented heights. In the developed world, trade was equal to roughly 20% of GDP from 1880 to 1914, reaching a low of ~10% in the middle of the 20th century, and not rising above 20% again until 1999 (figure 14). World trade declined so steeply in relation to global output during the war-torn middle of the last century that the period after 1945 was mainly about regaining the previous height of global integration. In terms of the relative importance of trade, in other words, we are living through Globalisation 2.0. The clear lesson of history is that the process of globalisation can be reversed, no matter how far it has advanced.

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41

14. imporTS AND exporTS from SeleCTeD DeVelopeD eCoNomieS AS A proporTioN of GDp
Trade as % of GDP 30 20 10 0 -10 -20 -30 1879 1888 1897 1906 1915 1924 1933 1942 1951 1960 1969 1978 1987 1996 1870 2005 -40

Imports

Exports

Source: mitchell (2003), oeCD Statistics Dept, United Nations, oliver Wyman analysis. Countries included: france, Germany, UK and italy 1870-2006, Japan 1885-2006, Spain 100-2006, Denmark and Netherlands 1132006, Norway and Sweden 115-2006, belgium 11-2006, Austria 12-2006, Switzerland 12-2006, portugal 150-2006, US 160-2006 and finland 171-2006

International financial markets have evinced a similar pattern. Cross-border capital market integration lost significant ground during the mid twentieth century, only recently exceeding the levels seen in the early 1900s. One way of illustrating this point is by measuring the differences in sovereign bond yields across markets both in terms of absolute differences and taking into account changes in the exchange rate between two markets. using spot rates and three-month forward rates between two markets as well as the yield on three-month treasury bills, we are able to determine the difference in expected yield in a unit of currency invested at the same time in two different countries, and hence the degree of capital mobility between them (assuming that there is no credit or transfer risk associated with the securities). Where a gap exists between the expected return on, for instance, a dollar invested in new york compared with a dollar invested in London at the same time over the same period, an arbitrage opportunity is created. Assuming perfect capital mobility, traders should quickly take advantage of this opportunity, thereby eliminating the gap. The average size of this arbitrage gap between the uS and the uK and between Germany and the uK was just 0.28% between 1870 and 1914, rising to 1.1%11 from 1914 to 1945, and 1.0% from 1945 to 1985, before falling again to 0.1% (see figure 15).

11 This figure excludes the 122 UK-Germany figure which was 7%

42

15. ArbiTrAGe GAp oN Three moNTh SoVereiGN DebT beTWeeN US AND UK, GermANy AND UK
4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.0%

1870

1877

1884

1891

1898

1905

1912

1919

1926

1933

1940

1947

1954

1961

1968

1975

1982

1989

US to UK SD
Source: obstfeld and Taylor (2002)

Germany to UK SD

In short, it would be a mistake to regard the past ten years as exceptional in terms of liquidity or global integration. We have been here before in the first age of globalisation before 1914 and history makes it clear that both liquidity and globalisation are capable of ebbing even more rapidly than they flow. The global environment cannot be counted on to remain as benign as it has been over the past decade. DemoGrAphiC TreNDS The demographics of the developed world have certainly changed quite dramatically over the past century as a result of improved life expectancy and reduced fertility. From the perspective of a century of history, however, there is nothing so very remarkable about the current and projected increase in dependency ratios. Overall, in fact, the dependency ratio has fallen from 38% in 1890 to 33% (see figure 16). What has changed is the composition of the dependent population. today around 16% of the developed worlds population is over 65, compared with just 5% in 1890, when the majority of dependents were children. The problem is that retirees cost up to two-thirds more than children to care for, mainly because healthcare for the old and decrepit is more expensive than education for the young and fit.

1996

THE EvoluTion of financial sErvicEs

43

under the welfare systems set up in the middle of the twentieth century, expanded in the 1960s, and only partially reformed in the 1980s, men and women often leave the labour force before they have ceased to be fit for work. All over the developed world, public and private pension schemes are already coming under strain for this reason. But simply raising retirement ages cannot be regarded as a panacea. It is far from clear that employers want to retain workers in their late sixties and seventies, not least because mental deterioration often precedes physical deterioration.
16. DemoGrAphiC ChANGe of SeleCTeD DeVelopeD CoUNTrieS
100% 80% 60% 34% 40% 20% 0% 32% 40%

38%

1890

1896

1902

1908

1914

1920

1926

1932

1938

1944

1950

1956

1962

1968

1974

1980

1986

1992

1998

Age 0 14

Age 15 64

Age 65+

Dependency ratio (right hand scale)

Source: mitchell (2003), liesner (18), US Census bureau, UK National Statistics, United Nations. Countries included are US, Japan, UK, Spain, italy, Germany, france and Switzerland.

GlobAl imbAlANCeS There is nothing new about large current account deficits and surpluses either. A hundred years ago, the uK ran very large current account surpluses. British savings (and the returns on past overseas investments) were channelled abroad on a huge scale, with a substantial portion going to the countrys imperial possessions. This was part of a large-scale flow of resources from Western europe to the rest of the world, including the uS (which didnt begin to export capital on a significant scale until the early twentieth century). By 1914, the gross nominal value of Britains stock of capital invested abroad was 3.8 Bn, between two-fifths and a half of all foreign-owned assets. Between 1870 and 1913 Britain ran a current account surplus that averaged around 4.5% of GDP, rising above 7% at cyclical peaks in 1872, 1890, and 1913. In modern parlance, there was a sterling carry trade, as uK investors sought higher returns in overseas securities than they could achieve at home.

44

2004

30%

From an accounting standpoint, British surpluses had to be matched by deficits in recipient countries. until the end of the nineteenth century, the uS was the biggest net capital importer. Subsequently, the British colonies of white settlement, as well as Argentina and Brazil, emerged as major destinations for British capital. By our standards, then, there clearly was some kind of global imbalance that allowed Britain to play such a dominant role in international capital flows. to contemporaries, however, this seemed like a stable disequilibrium, if not an age of equipoise. oVerVieW The defining feature of the twentieth century is the extent to which the world economy stagnated at the mid-point, regaining the peaks scaled prior to the First World War only in its later years. The key point is that the trend of macroeconomic change is neither linear nor evenly cyclical. History suggests that financial developments are characterised by punctuated equilibria. Projecting forward relatively recent trends must therefore be regarded with great caution need a better framework to make sense of very recent events.

THE EvoluTion of financial sErvicEs

45

OF CyCLeS, SurGeS AnD SPASMS

A longer-term view of the history of financial services underlines the danger of projecting forward the trends of the past ten years. Financial innovation has come in surges rather than as a steady stream. Financial services organisations have undergone a number of major evolutionary changes most obviously in the nature of banks and there have been many mutations in ownership and governance. new types of financial institutions have proliferated. The loNG rUN of iNNoVATioN There is nothing new about technologically driven improvements in the efficiency of financial services. A hundred and fifty years ago, the bulk of communications between financial institutions and their clients were handwritten on paper. Only gradually, as the telegraph network spread around the world, did cables or telegrams replace letters. The introduction of the telephone to banking was also a gradual process, as was the adoption of the ticker tape as a means of rapidly disseminating changes in stock market prices. It is easy to forget how recently the new york Stock exchange floor was carpeted with pieces of paper at the end of the trading day. In this context, the introduction of the desktop computer and basic spreadsheet was less revolutionary than is often assumed. It is true that AtMs reduced significantly the number of bank branch staff required and made employees into generalists, dealing with all types of customer need. But these innovations were spread over a longer period than is generally realised. The first AtM was introduced in 1967 forty years ago and the first desktop spreadsheet application in 1979. As figure 17 shows, improvements in productivity in financial services were minimal in the uS before the 1950s, but were then sustained, with only minimal reverses, until the 1990s. revenue per employee hour has risen from $42 in 1934 to close to $200 today. In Switzerland, revenue per employee hour rose from CHF 30 in 1938 to CHF 220 today, with a sharper acceleration in the past twenty years. The difference probably reflects the greater economies of scale possible in the uS in the period after the Second World War. In each case, the process of technological mutation led to significant improvements in commercial banking productivity only quite recently. The possibility cannot be discounted that we may now be on the threshold of another plateau, most of the benefits of computerization having already been achieved.

46

17. CommerCiAl bANKiNG proDUCTiViTy iN The US AND SWiTzerlAND


US Number of insured commercial banks 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 1934 1938 1942 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2002
0

Revenue per employee hour ($) 220 200 180 160 140 120 100 80 60 40 20 0

Switzerland Number of insured commercial banks 250 200 150 100 50 1934 1938 1942 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 0 Revenue per employee hour (CHF) 250 200 150 100 50 2006 0

Number of commercial banks Productivity (total income/man hour)

Productivity (interest income/man hour)

Source: fDiC, Swiss National bank, oliver Wyman analysis. employee hours are calculated as 8 hours per day for 230 days per year

The STrUCTUre of fiNANCiAl SerViCeS oVer The lAST 150 yeArS The ebb and flow of liquidity and of global integration have been the crucial environmental factors in the history of financial services. The twentieth century witnessed a dramatic rise, fall and revival of the industry, each stage of which was closely correlated to a change in the macroeconomic environment. In developed countries, banking assets as a percentage of GDP hit a peak of 113% in 1914 which was not regained (apart from during the extraordinarily low GDP levels of the Great Depression) until the 1960s, and not meaningfully overtaken until the late 1980s (figure 18). The World Wars and the Great Depression held back the financial services sector to such an extent that only in the last twenty years has it been breaking new

THE EvoluTion of financial sErvicEs

47

ground in terms of its relative economic importance. Deposits as a proportion of GDP stood at 66% in 1914, a level that was not exceeded in the second half of the twentieth century until 1987. today, banking assets as a percentage of GDP stand at 154% compared with 77% for deposits. Deposits have risen considerably more slowly than assets, as individuals today choose to place more of their wealth in mutual funds and other savings vehicles rather than in traditional bank accounts. The ratio of assets to deposits today is 2, compared to 1.7 in 1914.
18. bANKiNG ASSeTS AS A perCeNTAGe of GDp
200% World War I 1929 crash World War II

150%

100%

50%

1900

1905

1910

1915

1920

1925

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

Assets

Deposits

Source: mitchell (2003), fraser, fDiC, CUNA, oTS, bbA, oeCD, Sheppard (171), pohl (182), Goldsmith (183), Statistics bureau and Statistical research and Training institute of Japan, Swiss National bank, banco de espana, The bundesbank, The Shinkin banks research Centre, oliver Wyman analysis Note: Assets includes commercial, savings and cooperative / mutual bank assets. Deposits include commercial and savings bank deposits only

A rather different picture emerges in the case of insurance, which has seen a more sustained long-run expansion in terms of assets and premiums. As figure 19 shows, in 2000 premiums approached 10% of GDP, up from just 1% in 1880 and 5% as recently as the early 1980s. This difference partly reflects the relatively low penetration of insurance during the nineteenth century. However, it is also due to the increasing tendency for individuals to hold their wealth not in bank deposits but in cash-value insurance and insurer-provided annuities of various kinds, as well as in new investment vehicles such as mutual funds.

48

2005

0%

1. iNSUrANCe premiUmS AS A perCeNTAGe of GDp


World War I 12% 10% 8% 6% 4% 2% 1880 1884 1888 1892 1896 1900 1904 1908 1912 1916 1920 1924 1928 1932 1936 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004
THE EvoluTion of financial sErvicEs

1929 crash

World War II

0%

Source: Sheppard (171), mitchell (188), Great britain board of Trade, Annual Abstract of Statistics, oeCD, insurance Statistics yearbook, oliver Wyman analysis

If we think of the structural development of the financial services industry in the developed world as an evolutionary process, we can see at work the forces of

Competition and natural selection of those organizations with traits best suited to the slowly changing macroeconomic environment exogenous shocks in the form of financial crises, ranging from the huge disruptions of the Great Depression and World Wars to the smaller crises of more recent times

Over the course of the past century, the populations of different species within the industry have grown, shrunk, and on occasion become extinct as a result of these interacting forces Figures 20 and 21 track the evolution of retail and commercial banking, investment banking and fund management and insurance the three main phyla within the financial services sector. The thickness of each bar is intended to be roughly illustrative of the relative size and importance of that particular species in terms of the number of firms, their assets and revenues.

4

20. The eVolUTioN of reTAil AND CommerCiAl bANKiNG


1900 Internet/direct banks Telephone/direct banks Shareholder-owned private banks High-end private and merchant banks Commercial banks Full service retail and commercial banks Bancassurance Monoline consumer nance and mortgage Subsidiaries of major conglomerates Shareholder owned savings and loans Not for prot savings and loans Government owned deposit takers 1925 1950 1975 2000 2007

An example of the movements in the competitive landscape described in figure 20 is the emergence and retreat of bancassurance. This particular branch of retail banking evolved as a push by retail banks to leverage their branch networks in the distribution of non-traditional retail banking products namely, in this case, insurance. The merging of banks and insurers was largely a response to looser financial services regulation, though the model later turned out to be less successful than many had hoped, and bancassurance franchises became absorbed by universal, or full service, commercial banking organisations. It is often assumed that the most important trend in retail and commercial banking has been towards consolidation. However, figure 20 makes it clear that considerable bio-diversity remains. north America and to a lesser extent some european markets still have highly fragmented retail banking sectors. The cooperative banking sector has seen the most change, with high levels of consolidation (especially following the Savings and Loans crisis of the 1980s and similar events in other markets), and most institutions moving to shareholder ownership. But the only species that is now close to extinction in the developed world is the state-owned bank. Government ownership of banking organisations very prevalent in some countries from the 1940s until the early 1980s has declined steeply as a result of privatisation (but see below for a new manifestation of state ownership in the realm of investment management).

50

In other respects, the story is one of speciation the proliferation of new types of financial institution which is what we would expect in a truly evolutionary system. Many new monoline financial services firms have emerged in the commercial banking space, especially in consumer finance. For example, MBnA, established in 1982 as a subsidiary of Maryland national Bank, survived as an independent company from the time it was spun off in 1991 until 2005, when it was acquired by Bank of America. Other companies, such as Capital One, have remained independent, though many of these experienced difficulties during the credit crunch of August-September 2007. A number of new boutiques now exist to cater to the private banking market. Direct banking (telephone and Internet) is another relatively recent and growing phenomenon throughout the developed world. Branch networks have been bypassed for simple deposit-taking organisations, and even traditional non-direct banks are trying to reduce customer footfall in branches by offering more and more services online.
21. The eVolUTioN of iNVeSTmeNT bANKiNG AND iNVeSTmeNT mANAGemeNT
1900 Boutique/specialist investment banks 1925 1950 1975 2000 2007

Universal bank division

Shareholder owned investment banks

Private owned merchant banks

Boutique investment managers

Alternative investment managers

Private equity houses

Marketplace/ exchange

THE EvoluTion of financial sErvicEs

51

Alternative investment houses specialising in hedge funds, private equity or even both have been a relatively recent phenomenon, though both have existed in some form for many decades. The resurgence of specialist investment banking organisations has also been a recent trend, with an increasing number of small boutique shops competing alongside the global bulge bracket firms. Modern investment management has evolved in a similar way in the course of the twentieth century. There has been a trend towards consolidation, in the sense that publicly quoted investment banks have absorbed a substantial number of privately owned merchant banks, stock-brokers, and other entities since Big Bang in London (see Box 2). universal banks in the German tradition have gained in importance in this sector as regulations have eased, particularly following the 1999 repeal of the American Glass-Steagall Act, passed in 1933 to separate retail and investment banking.

52

box 2 loNDoNS biG bANG The Big Bang in London in 1986 was complex legislation deregulating the financial markets, including the removal of the distinction between stockjobbers (market makers) and stockbrokers. The resulting fallout was the rapid demise of an entire species of firm, as all the citys stockjobbers were acquired by either banks or stockbrokers. Since the Big Bang, Londons presence on the world financial stage has changed dramatically. The City is now the dominant financial centre in europe, and on some measures, the world. The stockjobbers were run as cliquey old boys clubs with little exposure to international competition. today, the market makers all sit within banks, most of which are not of uK origin.
SToCKJobberS Where Are They NoW?
Name Akroyd & Smithers Wedd Durlacher mordaunt pinchin Denny Smith brothers bisgood bishop Charlesworth What happened? bought by SG Warburg (subsequently acquired by UbS) purchased by barclays bought and eventually closed by morgan Grenfell (now part of Db) became Smith New Court before being purchased by merrill lynch bought by County Natwest (subsequently bought by SSb) part of Kleinwort benson

loNDoN reborN AS AN iNTerNATioNAl fiNANCiAl CeNTre


Measure* Domestic equities annual turnover lSe (bN) foreign equities listed on lSe foreign exchange daily turnover ($bN) UK private equity assets (% of european total) UK private equity fundraising ($mm) 1986 161 0 50 33.% 360 2005 2,45 2,703 1,210 66.7% 46,170

*Thomson financial, ifSl, london Stock exchange, bank of england

THE EvoluTion of financial sErvicEs

53

The total number of banks in developed countries peaked at the beginning of the 1920s (see figure 22). Subsequently, a wave of failures in the uS and europe during the Great Depression reduced the total number of banks by a third in a little over a decade. Since the mid 1980s, there has been a prolonged period of banking consolidation across all economies, driven by regulatory changes, the pursuit of economies of scale, and improvements in systems and technology. The trend of demutualisation has also reduced the number of mutual and cooperative banks by more than half in just twenty years.
22. NUmber of fiNANCiAl iNSTiTUTioNS iN SeleCTeD DeVelopeD CoUNTrieS
80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 1900 1904 1908 1912 1916 1920 1924 1928 1932 1936 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 0

Commercial Banks Mutual funds

Saving Banks

Mutual & Cooperative Banks

Hedge funds

Source: oeCD, bundesbank, Davies (2002), mura (16), Duet (186), btiz-lazo (2004), Sheppard (171), pohl (182), Torgerson (154), Schiffer (162), oliver Wyman analysis. Countries included are the US, Japan, UK, Switzerland, Spain, italy, france and Germany

As the number of banking organisations has been falling, however, the aggregate value of the industry has been rising, from just $1 Bn in 1890 in the markets of the developed world to roughly $5 tn today (figure 22). The expansion of American banks has been an important factor in this story. In 1965, just thirteen uS banks had a total of about 200 foreign branches. By 1987, the numbers had risen to about 200 banks with around 800 branches. As early as 1970 the deposits of uS banks with branches in Britain exceeded those of the uK clearing banks. yet, as figure 22 makes clear, financial evolution is not primarily a story of concentration but of speciation: with new forms of services and institutions emerging to take advantage of subtle changes in the economic environment.

54

23. eSTimATeD VAlUe of The fiNANCiAl SerViCeS SeCTor iN DeVelopeD eCoNomieS


Industry value ($BN) 10,000 Average rm value ($MM) 1,000

1,000

100

100

10

10

1911

1890

1897

1904

1918

1925

1932

1939

1946

1953

1960

1967

1974

1981

1988

1995

Industry value
Source: frASer, oeCD, Datastream, oliver Wyman analysis

Average rm value

even as giants have formed in the realm of investment banking, new and nimbler species of investment vehicles such as hedge funds and private equity partnerships have evolved and proliferated. Although the first hedge fund was established as long ago as 1949 (by the Columbia university sociologist Alfred Winslow Jones), their emergence as major players in global financial markets is a relatively recent phenomenon. In 1992, the SeC counted a mere 400 hedge funds with just $50 Bn of assets under management.12 By the end of 2006, the number had increased more than twenty-fold and assets under management by a factor of nearly thirty. As of the second quarter of 2007 there were 9,767 funds with $1.74 tn of assets under management, somewhat less than a tenth of the assets under management by, respectively, pension funds ($21.6 tn), mutual funds ($19.3 tn), and insurance companies ($18.5 tn).13 Because they do not come under the aegis of the Investment Company Act of 1940, hedge funds are able to pursue multiple investment strategies. At the time of writing, there were at least seventeen distinct hedge fund strategies, ranging from convertible arbitrage to short selling.14 The ability of hedge funds to leverage their positions greatly magnifies their share of global financial market activity. The estimated gross investments of the five largest hedge funds amount to around $100 Bn. For the sector as whole the figure is $6 tn. They now account for between a third and a half of all in trading in the uS and uK equity and bond markets.15
12 Securities exchange Commission (1). 13 hedge fund research, Alternative investment industry performance and Trends (2007) 14 Ackermann, mcenally, and ravenscraft (1). 15 mcKinsey Global institute (2007), pp. 10-14

2002

THE EvoluTion of financial sErvicEs

55

There has been a somewhat smaller surge in the number of private equity partnerships and the assets they manage, taking the total for assets to $710 Bn at the end of 2006. Most recently, there has been significant innovation within these new species, with several funds (i.e. Fortress) running multiple business lines. Others, such as Bain Capital and Monitor Clipper, have established partnerships with strategy consultancies. Sovereign wealth funds are also playing an increasingly important role in the realm of investment. even as the state has retreated from banking in most markets, the rapidly accruing hard currency reserves of manufactured goods exporters and energy exporters are producing a new generation of sovereign wealth funds. One estimate for the total assets under management by hedge funds, private equity, sovereign wealth funds and central banks is $8.7 tn. By 2012, the figure could be as high as $15.2 tn.16 Banking, then has undergone a profound transformation. usually innovation (mutation) has been an evolved response to the environment and competition, with natural selection determining which new traits become widely disseminated. Sometimes, however, this process has been accelerated or disrupted by major financial or regulatory shocks. The Great Depression of the 1930s and the Great Inflation of the 1970s stand out as times of major discontinuity, with mass extinctions such as the bank panics during the Depression and the Savings and Loans crises in the 70s. Could something similar happen in our time? The most famous hedge fund crisis to date affected just one firm (Long term Capital Management) in 1998. There was a lesser-known crisis in the 1960s when poorly hedged, highly leveraged positions unravelled fast, reducing the number of funds from 200 to less than a quarter of that number. In January 1989, there were just 143 hedge funds in existence. Between 1989 and 1996 1,308 new funds were formed. Of the total number of funds, 533 ceased to exist by the end of 1996, an attrition rate of just under 37%.17 The sharp change in credit conditions in the summer of 2007 created acute problems for certain hedge fund strategies (quantitative and long/short especially), leaving them vulnerable to redemptions by investors and/or absorption by investment banks. Another important feature of the recent credit crunch has been the pressure on investment banks to bring other kinds of relatively novel organisms (conduits and SIvs) back on to their balance sheets. Both trends seem certain to reduce the number of these entities within the next quarter, though there is clearly no danger of outright extinction.

16 ibid., p. 12 17 managed Accounts reports

56

even so, the long-run trend is very different from that predicted a century ago by socialist critics of finance capitalism like rudolf Hilferding, who assumed an inexorable movement towards more concentration of ownership. As in the natural world, the emergence of hungry giants does not preclude the evolution and continued existence of smaller species. Size isnt everything, in finance as in nature. Indeed, the very difficulties that arise as publicly owned firms become larger and more complex the diseconomies of scale associated with bureaucracy, the pressures associated with quarterly reporting make it very probable that new kinds of private firm will flourish. What matters in evolution is not your size nor your complexity, though evolution may have led you to become both big and complicated. All that matters is that you are good at surviving and reproducing your genes. The financial equivalent is being good at generating returns on equity and generating imitators employing a similar business model. Both are easier for small firms.
24. The eVolUTioN of iNSUrANCe
1900 Mutual life insurer 1925 1950 1975 2000 2007

For prot life insurer

Integrated insurer

Bancassurance

Non-life insurer

Mutual health insurer

For prot health insurer

Reinsurance

Marketplace/exchange

A parallel can be drawn between figure 24 and figure 20, both of which track the emergence and retreat of bancassurance. Firms were picked up from the insurance industry by banking organisations before, in many cases, remerging with insurance companies as ventures proved less successful than expected. Mutual insurers are a species that can be seen in figure 24 to be waning. As market share has been picked up

THE EvoluTion of financial sErvicEs

57

by for profit enterprises, the need for mutual insurers has diminished and many have either become, merged with or been acquired by for profit insurers. The modern history of insurance also tends to be thought of as a story of concentration and consolidation, with the emergence of a small number of giant global players. Here too, however, the more important trend is towards diversity. true, the global reach of the worlds largest insurers has increased in the last few decades, a trend dating back to the beginning of the twentieth century when companies such as Prudential (uK) began expanding overseas. yet the emergence of for-profit health insurers provides further evidence of the importance of speciation in the long run.

58

58

box 3 loNG-Term AND CyCliCAl GroWTh While the banking sector has enjoyed strong real growth rates for the past ten years, much of this is unusual in relation to longer-term twentieth century trends. The chart below indicates whether the change in financial services value relative to GDP growth over the same period has been running above or below expectations based on trend lines. examining the long-term growth trend of financial services value and its relationship to underlying GDP in the countries in which it operates, we can determine whether for any period of time the change in value has been running above or below trend, relative to the growth of GDP over the same period. The period 1980-2003 stands out in terms of the divergence of real and expected growth rates, with financial services currently growing at ~4% above trend. The 1914-1945 period was characterised by war, inflation, and depression, leading to low real growth. The more recent 1946-1979 period, characterised by high inflation and unstable markets, exhibited real growth of 5%, only just above the long-term average. The period 18731913 exhibited above-average real growth, though not nearly so detached from the drivers as today.
reAl AND expeCTeD GroWTh iN The VAlUe of The bANKiNG SeCTor 1873-2003
9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 1873-1913 1914-1945 Actual 1946-1979 Expected 1980-2003

Within each time frame examined, the business cycle has also played a role in the changes in value of the industry. Growth from 1995 to 2000, for instance, ran well above trend at 15% annually in real terms. Similar periods can be identified throughout the last 150 years.

THE EvoluTion of financial sErvicEs

5

oWNerShip Figures 20, 21 and 24 highlight several distinct trends in the ownership of financial services. early in the twentieth century, nationalised banking sectors were rare. In the middle of the twentieth century, by contrast, there was a surge of public ownership, most obviously in Central and eastern europe. The banking system was nationalised in India in 1969. The biggest French banks suffered a similar fate in 1981. The most recent trend (see figure 25) has been towards privatisation (technically the sale of state-owned equity to the public), though there remain some state-owned banks in Western europe (such as the German Landesbanken and individual institutions like Swedens soon to be privatised SBAB). Developing countries still have far greater proportions of state-owned banks, with China and India the two most obvious examples. State-run banks have tended to lag behind their private sector counterparts. In 2000, for example, non-performing loans at Chinese state banks equalled 18% of the total.18
25. NUmber of fiNANCiAl SerViCeS priVATiSATioNS ANNUAlly iN eUrope
Number of privatisations 25

20

15

10

1991

1985

1986

1987

1988

1989

1990

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Source: privatisation barometer. Covers all countries in europe

even as state-owned banks have declined in importance, many privately owned banks have moved towards public ownership through stock market listings or sales to already listed institutions. Allowing banks to become joint-stock companies enables them to acquire much larger capital bases. There are notable exceptions to this trend, however. Some smaller firms such as boutique investment banks and niche private banks have remained as partnerships or otherwise privately (sometimes family) owned. For other small financial services companies, such as hedge funds and private equity firms, private ownership has been
18 Nicholas lardy, institute for international economics

60

2007

the norm for decades, with only a handful of the bigger players recently electing to list on stock markets and sell equity stakes to the public. The emergence of private equity and other activist investors is not a new phenomenon, it should be noted. Indeed, if we look back a century, it represents a return to the days of purer capitalism. Whether this will be a cyclical blip or a fundamental shift in corporate ownership and governance will not be clear for some time. One of the forces driving the creation of private capital providers is producer compensation. The whole of financial services can be thought of as having three factors of production: human talent, financial capital, and infrastructure/technology. Over time, the importance of each of these ebbs and flows with the market environment, and hence the price of each oscillates. At some points in time, such as the private banking boom of the early twentieth century and the private equity boom of the eighties, talented individuals can get much higher compensation by taking slightly more risk and setting up their own businesses outside established firms. Are hedge funds and private equity partnerships the mammals in our evolutionary analogy, waiting to inherit the earth when the dinosaurs fall victim to severe change in the financial environment? Perhaps. At the moment, however, the relationship between small and large entities is more symbiotic than competitive a case of co-evolution in action. Where, after all, would the hedge funds be without their prime brokers? In evolutionary terms, then, the financial services sector appears to be in the midst of a kind of Cambrian explosion, with existing species flourishing and new species (like hedge funds and private equity partnerships) increasing in number. The GeoGrAphy of fiNANCiAl eVolUTioN Despite the differences among economies in terms of regulatory environments and cultures, most can be shown to exhibit broadly similar trends in the emergence of financial services organisations. The growth of investment companies, the penetration of investment banking, the demutualisation of life insurance and savings firms, and the evolution of alternative investment firms have occurred in many different countries at different times. If we accept that different countries will tend to evolve along similar but not identical paths which seems an obvious lesson of financial history then it is possible to see a pattern in the evolution of financial services. Financial intermediation does seem to correlate quite closely to economic growth, even if the causal relationship remains a subject for debate.19 Personal wealth, the main driver of change in financial services, is growing rapidly in the worlds developing economies. A wealthy middle class is
1 See e.g. Sylla and rousseau (2003).

THE EvoluTion of financial sErvicEs

61

emerging that demands an increasing range of choice and level of sophistication in financial services products. At the same time, the poor are beginning to use products like microfinance loans, deposit accounts and mobile phone payment systems. An examination of the current penetration of financial services within the worlds economies gives us a rough proxy for financial services sophistication and development. Figures for deposits per capita show us the relative penetration of financial services, while GDP per capita gives a proxy for the wealth of the population (see figure 26). The size and wealth of the middle and upper classes, those who use financial services more and with greater sophistication, are harder to quantify.
26. fiNANCiAl ASSeTS AS A perCeNTAGe of ToTAl WeAlTh AND GDp per CApiTA
Financial assets as a % of wealth Nascent 80% 70% 60% 50% 40% 30% 20% 10% 0% 100 India
1,000

Emerging

Advanced

South Africa Norway Japan UK

Canada Czech Republic Spain Italy China Bulgaria Russia


10,000

US France Germany

Hungary South Korea

100,000

GDP per capita ($)


Source: United Nations, oeCD, fDiC, peoples bank of China, oliver Wyman analysis

If we group economies according to their level of financial services penetration, we can broadly identify three groups of markets

Nascent markets are those with very low penetration of financial services. Large portions of the population in such economies still do not have a bank account and use only the most basic financial services

62

Emerging markets are those with a strong retail and business banking sector, high insurance penetration and fast-growing demand for investment products, insurance-wrapped savings, and investment banking products Advanced economies are those with a mature financial services industry experiencing fast growth in only the most sophisticated and innovative areas pioneering investment banking products (derivatives, structured products etc.) and complex investment vehicles and asset classes, including private equity and hedge funds

One example of the tremendous growth currently being witnessed in developing markets is the Industrial and Commercial Bank of China, which added more than seven million internet banking customers and 200,000 corporate customers in the first half of 2007, increases of ~50% year over year.20 Investment funds are simultaneously becoming very popular in China, with demand fuelling massive growth in any fund sold through a Chinese retail bank. The aggregate effect of these changes is to reshape the financial geography of the world. As emerging markets grow, new financial services hubs are emerging to complement and compete against the existing financial centres in the developed world. Long-established centres such as Hong Kong and Singapore are growing rapidly as the markets around them expand. new hubs like Dubai are also emerging in the states surrounding the Persian Gulf, capitalising on regional wealth and demand for emerging product sets such as Islamic finance (including takaful insurance, Islamic financing including sukuks, investment products, and Islamic retail and corporate banking). At the same time, it is striking to note that capital adequacy of banks in the developed world has been on a slow decline. In europe, capital is now equivalent to less than 10% of assets, compared to ~25% towards the beginning of the twentieth century (see figure 27). Much of this is attributed to the increasing diversification, in terms of both sector and geography, of the asset base of developed economy banks. The question remains how far banks in the developed world have the resources to withstand a period of reduced liquidity (in some segments of the financial system) and of increased competition from emerging markets. In other words, having evolved in such a way as to minimise the ratio of capital to assets, are european banks going to be vulnerable to a harsher macroeconomic environment in the wake of the credit crunch?

20 South China Morning Post, iCbC draws 30.7m online clients, 17 July 2007

THE EvoluTion of financial sErvicEs

63

27. CApiTAl AS A perCeNTAGe of ASSeTS iN eUropeAN bANKS


25%

20%

15%

10%

5%

Source: benink and benshon (2002)

oVerVieW The last century, in summary, has been characterised by relatively benign climates at the beginning and end, and a period of prolonged interruption which started in 1914 and did not die down until the 1980s. Though the drivers and effects changed over time, from war to recession to simply a lack of growth or integration, or even a combination of the three, the defining characteristic was disruption. The impact on financial services firms was severe. Borders were closed and capital flows stemmed by exchange controls or rendered impossible by war. This collapse of the international economy reduced the demand for financial services disproportionately compared to other sectors. Stock exchanges were closed for periods of time which today are almost unimaginable the new york Stock exchange closed for almost six months at the beginning of the First World War, the only multi-day closure during the past twenty years having been in the wake of 9/11. This survey of a century of trends in financial services highlights its similarity with an evolutionary eco-system neither develops smoothly and both are susceptible to long-dated cycles as well as sudden proliferation surges and extinction spasms. natural selection has tended over the long run to reduce the number and increase the size of certain species of financial institutions, but it has also allowed new species to form and to proliferate, often in very large numbers. There has been considerable gene flow between populations as, for example, American banks have exported their modes of operation to other financial centres, though the dominant trend is for genetic mutation rather than homogenization. The evolutionary process has been subject to recurrent exogenous disruptions in the form of geopolitical shocks, financial crises and

64

1900 1903 1906 1909 1912 1915 1918 1921 1924 1927 1930 1933 1936 1939 1942 1945 1948 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993

0%

regulatory interventions (or lapses). These shocks have led to significant changes to the financial population as whole, and even the outright extinction of entire species. The evolutionary process is indeed a complex one, not least because of the ebbs and flows of liquidity and global integration, the quite frequent but unpredictable incidence of financial crises and the erratic interventions of legislators. At first sight, there seem to be few rules that can be relied upon for very long few north stars that can be used by the various stakeholders to steer by. This complexity makes the role of regulators and policy-makers exceedingly difficult. regulators and policy-makers have the power to change the rules of the financial system at a stroke of a pen. This is perhaps the biggest difference between financial evolution and natural evolution, which is widely understood by scientists to operate without a divine guiding hand.

THE EvoluTion of financial sErvicEs

65

Whereas evolution in biology takes place in the natural environment, where change is essentially random in character (hence Dawkinss image of the blind watchmaker), evolution in financial services occurs within a regulatory framework where to borrow a phrase from anti-Darwinian creationists intelligent design plays a part. Darwins species of finches adapted by random trial and error to the islands on which they lived. In the same way, financial services firms evolve according to the peculiarities of their own environments. But what makes these environments distinctive is not just a matter of economic performance or culture. It also has to do with the role of regulation. Sudden changes to the regulatory environment are rather different from sudden changes in the macroeconomic environment, which resemble environmental changes in the natural world. The difference is that there is an element of endogeneity in regulatory changes, since those responsible are often poachers turned gamekeepers, with a good insight into the way that the private sector works. However, the net effect is the same as climate change in biological evolution. new rules and regulations can make previously good traits suddenly disadvantageous. The STAbiliSiNG effeCT of reGUlATioN In many ways, the existence of a large number of banks in the early twentieth century was an anomaly created by peculiarities of uS regulation. The 1864 national Bank Act significantly reduced the barriers to setting up a privately owned bank. Capital requirements for banking organisations were low for much of uS history. At the same time, there were obstacles to setting up banks across state lines. The combined effect of these rules was a surge in the number of banks during the late nineteenth and early twentieth centuries. Large numbers of under-capitalised banks were a recipe for financial instability. Bank runs were a regular occurrence and caused the demise of many financial institutions 4,000 in a single year during the Depression. The introduction of deposit insurance in 1933 did much to reduce the vulnerability of banks to runs. However, the banking sector remained highly fragmented until after 1976, when Maine became the first state to legalise interstate banking. The rise and fall of Savings and Loans was also due in large measure to changes in the regulatory environment. Designed to take deposits and supply long-term mortgages to local clients, S&Ls came under acute pressure during the inflationary 1970s. Partial deregulation in the 1980s encouraged some S&L managers to adopt reckless and sometimes fraudulent practices. A comparable episode in europe was the Secondary Banking Crisis in the uK between 1973 and 1975, which affected banks that had

tHe rOLe OF reGuLAtIOn: InteLLIGent DeSIGn?

66

been lending money for the purchase of consumer durables. In this case, a lifeboat operation prevented thirty of these firms from collapsing, and lent assistance to another thirty that were in difficulty. Similar interventions by the authorities can be seen to have affected the number of banks in developing economies. In newly independent India, for example, the authorities encouraged mergers and acquisitions. As a result, the number of reporting banks declined from 517 in 1952 to a low point of 90 in 1967. A chronic shortage of rural credit then forced a partial u-turn as the government encouraged the growth of cooperatives and rural branches, increasing the number of bank offices from 8,262 to 42,016. These examples illustrate the extent to which regulators can influence the evolutionary process of financial services, changing the environment in which evolution takes place and the rules under which it operates.
28. bANKiNG fAilUreS AND DepoSiT iNSUrANCe iN The US
Bank failures 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500
1865 1869 1873 1867 1881 1885 1889 1893 1897 1901 1905 1909 1913 1917 1921 1925 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005

Deposit insurance per account ($) 200,000 180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0

Number of bank failures


Source: fDiC

Deposit insurance limit

The primary focus of most regulators is to maintain stability within the financial services sector, thereby protecting the consumers which banks serve and the economy which the industry supports. Companies in non-financial industries (computing, for example, or automobile manufacturing) are neither so fundamental to the economy nor so critical to the livelihood of the consumer. The collapse of a major financial institution, in which retail customers lose current and savings deposits, is an event which any regulator (and politician) wishes to avoid at all costs a fact of which British authorities were painfully reminded in September 2007. Bail-outs of failing institutions by regulators through direct capital injections, brokered buy-outs, or

THE EvoluTion of financial sErvicEs

67

outright nationalisations have been a regular feature of policy making since the 1930s and still occur today. In return for their implicit or explicit guarantees to banks, legislators demand a relatively high level of regulatory supervision. One consequence of this special status is that deposit-taking institutions rarely outperform the sector average. Compared with other industries, performance differences among firms tend to be small within any given regulatory jurisdiction. Banks, in short, do not behave like software companies. The critical question that has raised its head once again in recent months is whether implicit guarantees to bail out banks create a problem of moral hazard, encouraging excessive risk-taking on the assumption that the state will intervene to avert illiquidity and even insolvency if an institution is considered too big meaning too politically sensitive or too likely to bring a lot of other firms down with it to fail. From an evolutionary perspective, however, the problem looks slightly different. It is, in fact, undesirable to have any institutions in the category of too big to fail, because without occasional bouts of creative destruction, the evolutionary process will be thwarted. The experience of Japan in the 1990s stands as a warning to legislators and regulators that an entire banking sector can become a kind of economic dead hand if institutions are propped up despite under-performance (see box 5). poliCy CoNVerGeNCe AND reGUlATory iNDepeNDeNCe Over the long run, national systems of banking regulation have changed and gradually converged. The central bank is a relatively modern invention, appearing in developed countries at very different times (see figure 29). The first true central bank (in the sense that it acquired de jure a monopoly on note issue and de facto the role of lender of last resort) was the Bank of england, founded in 1694, but not recognisably performing its modern role until after 1873, the year of Walter Bagehots definitive Lombard Street. The Banque de France (1800) was a napoleonic foundation; the German reichsbank (1875) a Bismarckian one; the Bank of Japan (1882) a product of the Meiji restoration. The uS had no central bank until the creation of the Federal reserve System in 1913. Before the First World War, monetary authorities were constrained more by the largely unwritten rules of the game that governed the gold standard and by widely divergent national statutes. The gold standard rules collapsed in the era of the World Wars, and most central banks became little more than appendages of national treasuries and finance ministries, regaining their independence only after the trauma of the 1970s inflation.

68

2. The eVolUTioN of CeNTrAl bANKiNG iN SeleCTeD DeVelopeD eCoNomieS SiNCe 1875
1875 1900 1925 1950 1975 2000 2007

US
1913: Federal reserve established

Japan
1882: BOJ established. Becomes LLR in the 1920s (after WW1)

France Germany
1876: Reichsbank 1946: Bundesbank

Italy
1893: Bank of Italy formed and given note issue monopoly in 1926 1936: Bank of Italy becomes true central bank

Spain
1874: Banco dEspana granted note issuance monopoly 1956:Banco dEspana nationalised

Switzerland
1907: Swiss National Bank established

UK

No central bank

Quaso-central bank

Full central bank

Within the last twenty years, however, there has been renewed convergence at the level of policy setting and decision making. exchange controls and other restrictions on financial services were dismantled in most developed economies in the 1970s and 1980s. Committees of experts are more frequently used to set key short-term rates, inflation targeting is more common as a goal of central banking, and central banks are increasingly independent from government. From 1990 to 1998 more than 50 central banks adopted an inflation targeting policy, compared with just 4 from 1960 to 1989. Money supply targets and exchange rate targets were adopted by, respectively, 23 and 26 central banks between 1990 and 1998, compared with 11 and 24 between 1960 and 1989 (see figure 30). Independence, measured by a set of criteria and scored from one to ten, has increased across central banking organisations in the developed world, though developing markets still lag behind (see figure 31). yet considerable differences of opinion remain as to the correct basis for the formulation and implementation of monetary policy. The distinctly eclectic approach favoured by the Federal reserve under Alan Greenspan appears to be continuing under his successor, and contrasts in rhetoric and in practice with the modus operandi of the Bank of england (which has pursued an explicit inflation target since 1997) and the european Central Bank (which under Jean-Claude trichet appears to retain at least a passing interest in monetary aggregates). The Fed takes an asymmetric view

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of asset markets, seeming to worry more about wealth effects on the way down than on the way up, and thereby giving rise to the notion of the Greenspan put on the uS stock market. In August 2007, the Bank of england was reluctant to inject liquidity into the markets on the ground that it would be bailing out reckless players. The european Central Bank, by contrast, injected significantly more liquidity more readily than might have been predicted on the basis of previous pronouncements. Convergence, in short, is very far from complete. Central bank independence remains a fragile construct, with politicians in Britain and France openly criticising their respective monetary authorities during the recent credit market crisis.
30. ADopTioN of exChANGe rATe, moNey, AND iNflATioN TArGeTiNG by CeNTrAl bANKS
Central banks using target 160 140 120 100 80 60 40 20 0 1960s

1982

1986

1990 Money target

1994 Ination target

1998

Exchange rate target


Source: Sterne (2001)

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31. CeNTrAl bANK poliTiCAl AND eCoNomiC iNDepeNDeNCe


Index of Independance 7 6 5 4 3 2 1 0 Political independence Economic independence
Not available Not available

Political independence

Economic independence

Developed markets
Source: Arnone, laurens, and Segalotto (2006)

Developing markets 1991 2003

For most of the past century, financial markets and financial services companies were very loosely regulated by present standards. Many central banks in the late nineteenth century were privately owned, and as such remained somewhat insulated from overt political influence. Indeed, it took some time for their directors to acknowledge the priority of their shareholders interests. Prior to the Great Depression, there was very little regulation, least of all in the uS where Hayekian free banking prevailed for most of the nineteenth century. That changed in 1934 with the creation of the Securities and exchange Commission, an independent, non-partisan agency with quasi-judicial powers. Between 1933 and 1940, six major laws were passed relating to the securities industry, which the SeC was empowered to enforce. no major change occurred to this legal framework until the passage of the Sarbanes-Oxley Act in 2002 which, like most such legislation, was enacted in response to a crisis (the wave of accounting scandals exemplified by the collapse of enron). The Financial Services Authority in London is of much more recent origin. Originally established as the Securities and Investments Board of 1985, the FSA took on its current form in 1997 at the same time as the Bank of england partially regained its independence in the determination of monetary policy.

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box 4 The JApANeSe bANKiNG CriSiS Sometimes it can be difficult to remember that large, well-capitalised and apparently stable banking systems can completely collapse. But it has happened several times in recent memory. Sweden saw its entire financial system hospitalised from 1991 to 1994, and Japans famously collapsed in 1997. Though the reasons for the collapse seem fairly obvious now, nobody saw it coming. In the post-war period between 1945 and 1973, Japanese banks enjoyed a position of pre-eminence. Savings were channelled into these banks and restrictions on other financing options made them the prime financiers. The 1970s, however, brought about regulatory changes that eroded their power base and left the Japanese banking system in turmoil. The reform process saw the deregulation of financial markets and easing of restrictions on the issuance of equities and bonds. Larger Japanese corporations once reliant on bank financing shifted to the bond markets, as did other investors looking for more attractive and easier options for financing and investment. Sticking to their traditional lines of business, Japanese banks turned their lending priorities to individuals and the commercial real estate industry, which are generally risky in nature. In the mid 1980s, high economic growth and near zero inflation boosted asset prices to unprecedented levels. This, coupled with aggressive lending in a bid to capture market share, left banks with large non-performing collateral-based loans when the bubble finally burst in 1989. Banks ratings declined, raising their funding costs above those of their clients. Clients began issuing debt rather than borrowing, further impacting the quality of the banks balance sheets. Many banks complied with Basel I at the time of introduction, using shares on the balance sheet to constitute much of the capital. The early nineties saw a tightening of lending requirements, but many problems were simply disguised: non-performing loans remained unnoticed, as they were simply restructured and reclassified; problem loans were moved to related companies whose financial status was not consolidated; convertible bonds were issued to improve the capital position of banks. Banks began to enter insolvency in 1997 as depositors aggressively removed deposits from weakened institutions, despite government guarantees. The government also injected 1.8 tn directly into banks, putting aside a further 60 tn to support failing banks. Banks were closed or suspended through much of 1997 and 1998.

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The Financial Supervisory Agency was set up and conducted a series of onsite evaluations of banks, concluding that their credit quality was massively underestimated. values of some banks turned negative when they were asked to increase their provisions on certain portions of the book. In September 2003, Japanese banks still had an estimated 21.5 tn of non-performing loans for which they had not made any provision.
WorlDS Top TeN bANKS by Tier oNe CApiTAl iN 187, 17 AND 2007
1987 1 barclays bank 2 National Westminster bank Citicorp 4 hSbC holding Chase manhattan Corp Agricole Group 1997 2007 bank of America Corp

Citigroup

3 hSbC holdings Credit Agricole Group Jp morgan Chase & Co. mitsubishi UfJ financial Group iCbC royal bank of Scotland

Credit Agricole export-import bank of Japan Sumitomo bank Union bank of Switzerland Deutsche bank

Citicorp bank of Tokyomitsubishi Deutsche bank bankAmerica Corp AbN Amro bank

Swiss bank Corporation fuji bank

Sumitomo bank Dai-ichi Kangyo bank

bank of China

10

Santander

Source: The banker

Following the crisis, Japanese banks all but disappeared from the list of the largest banks in the world, to be replaced by Chinese banks. Though banking crises in developed markets are by no means common, it would be foolish to believe that the list of the top ten banks in 2017 will resemble that of 2007.

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At present, most financial regulation is national in character. Here, too, we see an evolutionary tendency, as competition between different financial centres (notably new york and London) has led to pressure for harmonisation though the lustre of Britains principles-based approach has been somewhat tarnished by the northern rock debacle. efforts to create an international regulatory framework for financial services continue, with mixed results. The World Bank and the International Monetary Fund offer some kind of international structure for sovereign borrowing by poor or crisisstricken governments, but efforts to establish a regime to govern global capital flows (the way the World trade Organization governs trade) have so far proved fruitless. exchange rates since the collapse of the Bretton Woods system in the early 1970s have been determined by central banks on a largely ad hoc basis, with only occasional collective accords. The most important international regulatory advance has related to bank capital requirements and has been carried out under the auspices of the Bank for International Settlements. It remains to be seen what the effects will be of the transition from Basel I (agreed in 1988) to the more sophisticated rules of Basel II, which are due to be adopted by at least 95 national regulators by 2015. oVerVieW The global financial services industry operates under a multitude of legal and regulatory frameworks, many of which overlap and are inconsistent with each other. The principles of Darwinian natural selection can, in theory, apply to regulatory frameworks as well as to financial services providers. However, in practice, no dominant intelligent design can hope to emerge in a context where there are no universal metrics of success and where political interference is a regular occurrence. Given all this, it is not surprising that the impact of regulation has been, at best, mixed. regulators seem to face a number of conflicting objectives. Protecting the consumer adds cost indiscriminately to all providers. encouraging new entrants creates new risks. Increasing transparency can punish innovators. More level playing fields actually favour the least efficient incumbents. Investor protection can lead to prolonging the life of failed business models. What is an enlightened regulator to do? What can a wellmanaged firm reasonably expect the regulators to do? In the next chapter, we seek to draw some conclusions from our evolutionary account for the sector and to offer some medium-term guidance for financial service providers and regulators.

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Going beyond superficial Darwinian analogies, our historical approach offers an adapted version of evolution as a framework for understanding the development of financial services. In this chapter, we describe the main elements of this framework and then apply it to make sense of historical facts and apparent paradoxes. We draw practical lessons about financial services of the future and apply them to a few concrete problems that the industry faces today. AN eVolUTioNAry frAmeWorK There are three fundamental reasons why we see evolution as a better framework for understanding financial services. First, neither evolution nor financial services has a single, long-term objective function. evolution does not have a purpose and does not, inherently, prefer certain species or attributes to others. It does not aim (as used to be thought by anthropocentric victorians) to produce homo sapiens as the finished product of life on earth. The provision of financial services does not have a single end-goal either. In the late 19th century, for example, the facilitation of trade and gold convertibility were paramount objectives, closely followed by the mobilization of small savings into the bond market via savings banks. Altogether different priorities dictated the evolution of finance in the 1940s and 1950s, when most financial institutions found themselves subordinated to national plans for wartime destruction or peacetime reconstruction. Objectives differ across geographies and end-user segments, and are often conflicting even in the same segment. Some microfinance lenders, for example, are in business to make a profit; others are in business to help the poor. In short, it is impractical to define the desired end-state of financial services through a finite number of objective metrics. Far from converging towards a single performance measure, evolution ensures that there will continue to be speciation among service providers, just as there will be increased diversity among end-users. Money can change hands in a multiplicity of ways for a multiplicity of purposes. In both financial and biological evolution, the sole common objective is to avoid disappearance. Second, no formula works forever. Species that prosper and seem indestructible for long periods can still fall victim to competing species or environmental changes. This is also fundamental to financial services: There is no perfect provider type (or regulatory framework) that will remain successful and dominant into the future. Structures that were highly successful in the past for example, the German three pillar system

evOLutIOnAry LeSSOnS In FInAnCIAL ServICeS

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of banking eventually come under pressure and decline in their effectiveness. Barriers to entry may, indeed, stay very high for long periods as in the case of large loss insurance during the 19th century, or the current scale game in custody services. However, seemingly failsafe formulae stop working as alternatives surface, technology advances, and the economic environment changes. Indeed, an important similarity between financial services and an evolutionary system is that the more successful a form becomes, the less robust it gets if the result of its success is that variance declines. Sometimes it really is the case that the bigger they come, the harder they fall. Third, mutation is built into the system. In financial services, perturbations arise from the human element, inter-connectivity, and exposure to external forces. Without ongoing change, the tendency would be to drag financial services down to the lowest common denominator; that was the root of the problem in 1980s Japan. Perhaps there really would be consolidation and convergence into one vast global monopolist, as the socialist theorists of a century ago imagined. In practice, over the long term we see greater diversity and higher rates of innovation in financial services. We estimate that over half of todays high-growth, highprofit segments of the industry exist as a result of small changes either proactive experiments or reactions to external stimuli that then led to the creation of new markets or new ways of delivering traditional services. As with evolution, the majority of mutations are unsuccessful, but without them the end result would be stasis rather than the vibrancy that we observe.

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These fundamental forces set up a dynamic environment that continues to generate new forms both randomly and (unlike in natural evolution) through conscious adaptation to external changes.
Rapidly changing environment Multiple, overlapping shifting objectives

Mutation

No formula works forever

No single, stable objective

Spontaneous new

Adaptive

Extinct

No convergence; Continued evolution Pool of forms

Time (decades)

A further important point is that the stakeholders in financial services are also part of the evolutionary process of change. Over a long period of time, the needs and preferences of end-users, employees and investors change as greatly as those of financial service providers and regulators. The table below gives a few examples of broad changes that have happened over long periods and that have set off new internal dynamics within the framework.

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Internal change Small- and medium-sized enterprise focus shifting from working capital financing to strategic advisory Super-wealthy agenda shifting from wealth creation/protection towards addressing global issues

Pressure points banks had invested in expensive distribution but their core product credit has lost relevance private banks and wealth manger solutions woefully inadequate for the truly rich

Impact on evolutionary process encourages new forms of direct lending to Sme segment; places traditional Sme models on the endangered list encourages captive wealth managers as a new evolutionary form; strengthens chances of not-for-profit organisations to increase market relevance Shifts evolutionary momentum from investment sales to individuals towards financing state institutions opens up major parts of traditional financial services to tech-savvy provider forms; can create hidden regulatory problems forces sharper distinction between customised distribution firms vs. scale manufacturing; opens up vast parts of the industry value to alternative providers and alternative investors explicit or hidden public-toprivate forms emerging in financial services will favour advisory boutiques and firms that tolerate high pay-out ratios to producers Catalyst for a whole new wave of alpha-driven asset managers; by nature these are more transient and more volatile Net loss to the system as superior forms are excluded from large parts of the environment, and as ultimately doomed forms are kept alive in sanctuaries Creates randomised speciation opportunities and elongates certain extinction trajectories

mass retail agenda not shifting from consumerism to old-age provision young generations expecting joined-up technology solutions to all financial needs

Governments facing implicit longdated expenditure demands

financial services firms have become technologically irrelevant, despite spending 20-50% of their cost base on technology and operational processes Cost of bespoke modules will spiral, while cheap whole platforms will lose distinction

Service provider agenda (to consumer financial service providers) shifting from micro- product provision to platform outsourcing

Top-end employee preference shifting from tenured salaries to profit/equity ownership

Difficult for intellectual capital businesses in financial services to deliver consistently to shareholders

investors attaching higher premium to owner-like managers regulators increasingly regarding the status quo as a good in itself

Traditional asset managers (especially active ones) losing market share rapidly pockets of suppressed evolution co-existing with market-driven forms will impose significant hidden costs on protective domestic macroeconomies A new source of largely inexpert capital will further reduce cost of capital on an arbitrary basis

Sovereign wealth funds reemerging and becoming more actively involved in financial services

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to illustrate the power of this framework, it is instructive to compare its features with two alternatives that have been implicit in the observations and actions of many industry participants.
Evolutionary Overview A dynamic equilibrium where all aspects of the industry evolve due to a complex set of drivers, with no convergence possible Deterministic An adaptive system where a number of fundamental rules prevail, so that the results of any stimulus can be predicted with enough information, and given enough time a static equilibrium can be reached

Stochastic A randomised system where responses to events are drawn from explicit or implicit statistical functions and where no equilibrium is possible

Fundamental drivers

Current pool of forms mutation lack of single objective No stable formulae Uncertain outcome of environmental impact

Underlying set of rules linking inputs to outputs external inputs

Underlying set of stochastic functions linking stimuli to responses

Applicability

most useful when there are both long-term trends and short-term effects in play Dynamic and driven by both external and internal economic and other needs Dynamic and subject to adaptation and spontaneous creation / extinction Complex, interdependent and shifting over time

most useful when stable relationships are observed between causes and effects formulaic and subject to stages of development

powerful when range of outcomes is more important than specific outcome scenarios randomised with directional progress and significant nonpredictable variation around the mean random so that unexpected successes and failures are the norm irrelevant unless certain groups can re-shape underlying stochastic processes pattern-less drift through future macroeconomic and environmental scenarios observed in rapidly expanding new market sectors where no clear winners can be discerned yet Create insurance mechanisms against the extreme downside scenarios and plan responses in an inherently random world

Demand structure

Supply structure

formulaic and resulting from shifting prices of factors of production owners of factors of production (human, financial and infrastructural capital) as the key determinants inexorable drift towards a stable equilibrium where a complex objective function is maximised observed in highly planned economies and/or highly regulated domestic finance sectors Continuously look for the grand rulebook that defines a successful finance industry

Stakeholder hierarchy

Endgame

Continued dynamic equilibrium that sees adaptation and creative destruction on a syncopated basis most clearly observed in least regulated parts of the industry, e.g. hedge funds Do not waste resources on controlling evolution; create transparency and level playing fields to the extent possible

Relevance to todays financial services world

So what if it is right?

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In the following sections, we demonstrate the usefulness of the evolutionary framework by applying it to past events, current challenges and the future of the industry. DrAWiNG leSSoNS for The fUTUre Let us now review the principal environmental and evolutionary tendencies, to see how far we have left the consensus view behind.
Consensus view Macroeconomic stability Unsupported Shortfall versus evolutionary perspective macroeconomic instability was a hallmark of the mid-twentieth century; todays stability resembles that prior to the first World War liquidity, though high today, has been higher before and has disappeared suddenly in past crises Society is beginning to support an increasing number of dependents, but the dependency ratio is not close to its historic high The world has been very globally integrated before as integrated as it is today. The period from 114 to 17 revealed the ease with which integration could be reversed and the difficulty of restoring it past technological innovations have not always translated into major gains in financial sector productivity The new ownership structures seen today are not significantly different from those seen throughout history The financial system is not necessarily more stable today than during the laissez-faire era of the late nineteenth and early twentieth century

Liquidity and global integration Demographic change

Unsupported

Unsupported

Global imbalances

Unsupported

Technology and productivity Risk management Ownership

Unsupported

Supported Unsupported

Regulation and supervision

Unsupported

mACroeCoNomiC STAbiliTy

relative macroeconomic stability has been a hallmark of the last decade, no doubt, but in the context of history it is relatively unspectacular. Most measures show the world economy to have been equally dynamic at the end of the nineteenth century, though growth in the first age of globalisation was admittedly somewhat lower and more volatile. There is no guarantee that volatility will not return with a bang in the decade ahead.

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liqUiDiTy AND GlobAl iNTeGrATioN

Though undoubtedly higher today than it was 20 or 30 years ago, liquidity is not exceptionally high in a longer-term perspective, at least by some measures. The increasing liquidity of assets other than cash and deposits means that using the money supply as a measure of overall liquidity can give an incomplete picture. The stock and bond markets have outgrown the money supply, and are larger as a proportion of GDP today than they were a hundred years ago. Moreover, the evolution of capital markets has meant that more and more assets have become liquid in the sense of being quickly and easily tradable at a market price. even real estate is now traded through reIts on stock exchanges, albeit in negligible volumes compared with the universe of real estate and the trade in other liquid assets. This is the sense in which the financial world today is awash with liquidity. nevertheless, recent events have exposed the potential for acute illiquidity in new markets that have arisen outside the traditional framework of the stock and bond markets. CDOs, especially those secured on sub-prime mortgages, have proved to be potentially highly illiquid, even the tranches classified as AAA by the rating agencies. In August 2007, a number of banks and other institutions that held CDOs found themselves in such difficulties that central banks were forced to act not only as providers of liquidity but also as lenders of last resort through the discount window. Peer institutions were unwilling to lend, given that the value of the CDO tranches, SIvs, and conduits they held had become impossible to measure, the secondary market having all but collapsed. This reduced the ability of banks to measure their own potential losses and each others potential riskiness. The lesson is clear: Liquidity can disappear very suddenly from a segment of the financial system, even at a time when it seems to be abundant in the system as a whole. The current turbulence in the credit markets points to just such a downturn in the liquidity cycle. Here we use another definition of liquidity: the ease with which an asset can be bought or sold on the stock and bond markets. As figure 32 shows, bid-ask spreads have fallen considerably since the early 1990s (some of which can be attributed to technological improvements in trading systems), but they are now edging upwards again. Though this metric measures just one aspect of liquidity, it may be suggestive of a broader change.

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32. AVerAGe biD-ASK SpreADS oN WorlD SToCK exChANGeS


Contraction Contraction Contraction?

2.50% 2.00% 1.50% 1.00% 0.50% 0.00%

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Source: Datastream, oliver Wyman analysis

Our own measure of liquidity also contracted during the volatile markets of 1997 and 2000, slowly expanding thereafter (figure 33). The liquidity metrics driving the downturn vary on each occasion, however. During the summer of 2007, bid-ask spreads and short-term money market rates were strong indicators of the downturn, while in 2000 it was the money supply that fell sharply.
33. liqUiDiTy DUriNG TimeS of CriSiS
Oliver Wyman Rebased to 100 at liquid peak 120 110 100 90 80 70 60 50 40 30 Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 2000 Month 7 Month 8 Month 9 Month 10 April 2000, May 1994, August 2007

1994

2007

Source: Datastream, World federation of exchanges, oliver Wyman analysis

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2007

each peak signifies a drying up of liquidity. Bid-ask spreads widen and interest rates rise as money becomes more scarce and expensive. The capacity of central banks as lenders of last resort is critical during these stages in the cycle. By injecting liquidity into the market, central banks enable financial services organisations to cover positions without incurring large losses. There was no real reason prior to the summer of 2007 to believe that this cycle had been abolished.21 Central banks tend to act as lenders of last resort to their national (or, in the case of the eCB, regional) markets. yet globalisation means and certainly meant last summer that a liquidity crisis in London can have an impact on other financial markets. As we have seen, although it is quite integrated today, the world economy is not exceptionally integrated in the context of the last hundred years. Further integration in the coming decade, however, would take us into uncharted waters. Clearly, global financial integration has the great benefit of allowing the savings of Asian and Middle eastern economies to be channelled into the debt markets of countries with a higher propensity to consume. On the other hand, global integration has attendant risks. even in times of relatively low global integration, major financial crises can quickly spread across borders. In todays world, the potential for contagion is arguably higher than ever. Stock markets have shown remarkable levels of correlation with one another in times of prosperity and during extreme crises (see figure 34). The three peaks in correlation during the twentieth century occurred during and prior to the First World War (Globalisation 1.0), during the Great Depression and again today (Globalisation 2.0).It was notable that all stock markets were negatively affected by the August credit crunch, and all responded in unison to the accommodative moves of the Fed and the eCB. An integrated global economy, in short, may be more susceptible to contagion than a non-integrated one. to be sure, the more integrated economies are, the less protracted crises tend to be. Capital is able to move to affected areas much faster and in greater quantities, and open economies can return to growth much faster than closed ones, as trade helps fuel demand when domestic consumption is weak. nevertheless, the susceptibility of globalisation periodic and highly correlated crises remains a critical feature of the macroeconomic environment.

21 Sir Andrew large, Why we should worry about liquidity, financial Times, 11 November 2004

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34. GlobAl SToCK mArKeT CorrelATioNS


Correlation of world stock markets 1.0 0.8 0.6 0.4 0.2 0.0 -0.2 1870 1878 1886 1894 1902 1910 1918 1926 1934 1942 1950 1958 1966 1974 1982 1990 1998 2006 Ten year correlation Twenty year correlation World War I World War II

Source: Global financial Data. Correlations are for US, UK, france and Germany plus Japan from 116

DemoGrAphiC ChANGe

High dependency ratios are nothing new, but there is a difference between a youthful society and an aged society. Current demographic trends clearly favour the economies of younger developing countries, whose share of the worlds working age population is expected to increase from ~80% today to ~90% by 2050 (see figure 35). The major impact of demographic change will be a shift in the way that societys dependents are supported, rather than a crisis resulting in the cost of dependents becoming overwhelming.

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35. DeVelopeD AND DeVelopiNG eCoNomy ShAre of WorlDS WorKiNG AGe popUlATioN
Forecast 100% 90% 80% 70% 60% 50% 40% 30% 20% 10%
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

0%

Developed country share


Source: UN, oliver Wyman analysis

Developing country share

At the country level, there may well be individual pension fund crises in developed economies. The legacy of Chinas one-child policy will clearly create a major difficulty for that country in the foreseeable future, as the dependency rate soars. today, less than 8% of Chinas population is 65 or older. By 2050, that proportion could have risen as high as 24%.
GlobAl imbAlANCeS

It is widely taken for granted that the growth of the economies of China and India is unstoppable, and that the financial services sector in Asia will grow proportionately to or even faster than the economy as a whole. There are, however, several potential obstacles to the unfettered growth that the financial services sector is now experiencing in China. As profit margins rise through innovation and scale benefits, there is the potential for a regulatory backlash aimed at checking these trends. Capping of interest rates, taxation, or other barriers would all slow the growth of the industry. If China were somehow to avoid a serious financial crisis in the next decade, it would become the only country in history to have industrialised without one. China has come a long way in terms of recapitalising its banking system. It has made (and is still making) a series of welcome and crucial reforms. risk measurement capabilities have considerably improved. But the fundamental approaches to capital allocation and risk management remain unreconstructed in many cases. With balance sheets expanding rapidly as the economy booms and large numbers of retail and commercial customers

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begin using financial services, difficulties seem certain to arise. A financial crisis in China could be triggered by a number of different events, including a sudden, major revaluation of the yuan or a crash of the Shanghai stock market (which at the time of writing, is exhibiting distinctly bubble-like characteristics). It seems reasonable, in short, to assume that the near future will not necessarily be like the recent past. The long-term perspective makes us aware of a whole range of ways in which the global economy could suffer setbacks in the decade ahead. Having reviewed the prospects for the global environment, let us now turn again to the evolutionary processes at work within the financial services sector.
TeChNoloGy AND proDUCTiViTy

There are two schools of thought about the impact of technology on financial services: either they treat technology as an external given that comes from outside financial services and impacts everything including that industry, or they see innovation as an amorphous mass of experiments that are partly endogenous. Both of these perspectives, nevertheless, encourage us to expect continued rapid innovation. nevertheless, a longer-run view suggests that technological innovation is not guaranteed to generate productivity gains on the scale we have witnessed in recent decades. As we have seen, there was very little technological innovation in financial services until the 1960s and 1970s, despite the fact that the first half of the twentieth century witnessed exponential technological advances in a wide range of other economic sectors. The possibility exists that the computer revolution has done most of what it can do to improve productivity in financial services. This scepticism may be consistent with the observation that many new financial service providers are relatively small entities (like hedge funds and private equity partnerships). Though all make some use (and a few make a great deal of use) of computerised trading systems, to a large extent these firms deal with their investors and targets of investment opportunity on a personal, face-to-face basis. The relationships involved are unlikely ever to be automated in the way that the relationships between a retail bank and its account holders have been in recent years.

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riSK mANAGemeNT

risk transfer through more developed cash, capital, and derivatives markets has enabled the management of credit risk to be much more efficient than in the past. to be sure, the transition away from traditional balance sheet banking is by no means complete. Deposits remain the single most important source of bank funding worldwide, and in some markets, notably the uS, generate more banking profit than any other product. nevertheless, investors appetite has grown dramatically for secondary loans and other financial assets originating at banks in the form of MBS and ABS, products that were effectively non-existent as recently as 1980. Though direct sales of loans (including the entire books of banks in financial difficulty) are nothing new, it is only recently that an active secondary market has developed for securitised products (though secondary trading in syndicated loans was common during the 1980s). As commoditised and homogenous securities, MBS are much more actively traded and considerably more liquid. A liquid market for bank-originated assets enables much faster, more effective, and cheaper risk management. The use of derivatives has also increased significantly. total derivatives outstanding were negligible in the mid 1980s compared with today, while the market for CDS was still tiny as recently as 2000 (see figures 36 and 37). Derivatives growth over the last decade has been driven more by credit products than by market risk products, which also began to grow rapidly in the 1990s. CDS purchases have grown especially quickly (though they make up a small proportion of total derivatives sales), largely due to rising demand from banks stemming from the introduction of the Basel II regulations. total OtC derivatives outstanding amount to ~$400 tn, of which CDS account for ~$30 tn. It is in this area that risk management has evolved the most over the last decade, not only by allowing banks to hedge and manage credit risk (historically the most frequent cause of bank failures), but also by allowing hedge funds and other investors actively to trade credit risk exposure in a way never possible in the past. Though syndicated loan trading increased hugely during the 1980s and 1990s, the current ease with which credit risk can be managed would have been hard to imagine even then, let alone a hundred years ago. Here we are very clearly in new territory without historical precedent to guide us.

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36. oTC DeriVATiVeS oUTSTANDiNG


National amount outstanding ($BN) 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Internet rate contract Commodity contracts


Source: iSDA, biS

Foreign exchange contracts CDS Other

Equity-linked contracts

37. oTC CDS oUTSTANDiNG


National amount outstanding ($BN)

35,000 30,000 25,000 20,000 15,000 10,000 5,000


0 2001
Source: iSDA

2002

2003

2004

2005

2006

It is not difficult to visualise a future in which banks have fully separated the management of the asset side of the balance sheet from the origination of assets in the market. As the stalling of credit markets during the summer of 2007 revealed, the movement to full separation of risk origination and balance sheet management in banking is far from complete. Our sense, nevertheless, is that the benefits of these innovations will continue to outweigh the costs that were revealed last August. In evolutionary terms, financial institutions that fail to exploit the new financial

88

technology and risk management are almost certain to lag behind their more adaptive competitors. In this one respect, we feel that the conventional wisdom is validated by our long-term survey of the financial evolutionary process.
oWNerShip

nothing better illustrates the degree of diversity in the financial services sector than the variety of structures of ownership that currently co-exist. State-owned banking organisations are certainly less common today than they were fifty years ago. But conglomerate ownership of financial services operations by the likes of Ge, by contrast, appears to be enjoying a resurgence. retailers and manufacturers are also entering the markets for banking and consumer finance in europe, while in Asia the South Korean chaebols and their financial services subsidiaries are becoming ever stronger. Though ownership of the largest financial services organisations is now almost exclusively through joint-stock structures, more and more smaller organisations are now very commonly privately owned, in the same way that many of the most important financial services companies of the early twentieth century were also privately owned. If private equity and other active investors demonstrate consistently superior returns in more difficult economic conditions, this may prove to be the beginning of a fundamental change. One scenario is that activist investors might attract an increasing share of collective savings, at the expense of more passive institutional investors. More probable, in our view, is the evolution of a symbiotic relationship between the large institutional investor species such as pension funds and insurance companies and the new species of more agile, aggressive investors. The former will either acquiesce in or, more likely, positively support moves by the latter with respect to specific investment decisions (as we have already seen happen in cases such as the ABn AMrO takeover battle). Moreover, the move towards more active institutional investment could itself create some second-order effects. First, companies in more open national or regional markets may create even more value and therefore be better equipped to grow beyond these markets, increasing their global market share. Second, in the short term, as a consequence of tighter financial management, companies at the margin may become less able to withstand financial pressure in periods of post-recession recovery, when reflation of balance sheets often strains to the breaking point less well-capitalised companies, at a time in the cycle when bank finance is less available. Third, more volatile employment markets may create potential backlashes from organised labour, which is already viscerally suspicious of private equity.

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reGUlATioN AND SUperViSioN

The mainstream view is that by learning from the past and having better policy tools, the financial services sector is more resilient to external shocks. This view seems highly dubious. Major firms continue to get into difficulties in highly developed economies despite all manner of regulation, supervision, and systemic protection northern rock in the uK, Countrywide in the uS and IKB in Germany are just the latest examples. The shortcoming of the consensus view is, again, embedded in its fundamental precepts. under a deterministic model, past mistakes should, indeed, help to create better solutions in the future and over time the whole system should indeed be made more robust by the repeated application and refinement of such solutions. under a stochastic model, events belong in the tails of the probability distributions that govern everything, and until the shapes of these distributions change we should expect the same types of shocks as we have seen in the past and having lived through the previous ones should be better prepared for the future ones. neither of these models generates the right answer here, as the industry keeps experiencing new shocks that surprise the most seasoned participants. under the evolutionary model, which posits that no formula works forever and that there is no single objective function, the expected outcome is different. This model predicts that there will be new and different types of external and internal shocks to come; that past responses to these shocks will not necessarily work; and that large-scale changes will be seen in the industry landscape, try as we may to avoid them. regulators and supervisors therefore have a privileged position in the system of financial evolution, but they also have limited power. They cannot change the macroeconomic context, nor the fundamental forces driving financial services and other sectors. What they can do is to act as the guardians of transparency, to generate early alerts of specific negative scenarios, and to help accelerate moves back to market normality when manageable shocks occur. This is a very different regulatory/supervisory agenda from traditional models, which tend to be focused on consumer protection, systemic risk management and financial stability. A clear implication of the evolutionary model is that none of these traditional objectives of regulation can be achieved at all times. Indeed, by setting up such objectives for regulators and supervisors of financial services, policymakers are simply creating a pipeline of future failures which in reality are failures of expectation rather than of the regulatory framework. today, regulators seem increasingly to be running the risk of preventing creative destruction from ever happening in regulated finance (i.e. banking). In our view, this is more a serious problem than moral hazard, since it risks the prolonged survival of the

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unfit. On the other hand, so long as new entities (hedge funds, private equity) can arise and operate outside the pale of regulation, the sector as a whole will remain dynamic. We would therefore be firmly against any significant extension of the regulatory pale, despite the repeated calls from American and european politicians for tighter control of hedge funds and private equity.

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prACTiCAl leSSoNS for iNDUSTry leADerS In reading the above, industry leaders including chairs of supervisory boards, CeOs and heads of strategy, could be forgiven for treating it merely as an interesting historical treatise. As with most new paradigms, the evolutionary theory of finance does not offer conventional lessons to practitioners. The take-home here is not simply grow or die, diversify or perish, stick to your core knitting or unravel alluring though such simple mottos may seem. In this section we suggest some more profound lessons and apply them to a few of the problems, that many industry participants currently face.
Lesson 1 Keep it natural In finance, as in the biological world, natural is best. This plays out in multiple ways for the top leaders of a firm. natural evolution, based on building incremental capabilities, markets and businesses, works well and creates sustainable entities in a world that is inherently volatile and instable. This type of evolution can be through organic or non-organic growth, or even through spontaneous creation of a small, innovative fast growth firm. By contrast, forced evolution the type that creates a Frankenstein monster by bolting together unconnected entities with different DnA and metabolisms invariably fails sooner or later. As a chairman of a bank or insurance company, are you presiding over the creation of an entity that is evolving logically relative to its current form and available habitats? Another aspect of keeping it natural is to make sure your internal rules reflect the rules of the real world. too many financial services providers fall into the trap of managing their key resources (human talent and their time/energy, economic capital, investment funds, customer franchise) according to esoteric internal lenses that drift far off the external world. If a wholesale bank does not differentiate bonuses greatly between superb and average producers, it will lose its best people because the market certainly makes such distinctions. If a payment processor deploys technologies that treat all customers as the same average customer, it leaves the door open for many new entrants. If you allocate capital according to old models that do not reflect economic risks, you will lose volumes or value or both. Finally, top management needs to be aware of unnatural habitats created by either too little regulation, or the wrong type of regulation. These usually manifest themselves as hugely attractive markets that are highly protected (e.g. banking supervisors who discourage foreign entry into a country), very high growth detached from fundamentals (e.g. sub-prime mortgages and consumer finance), or very low risk (e.g. countries where the state always bails out companies for political reasons). Such markets are decoupled from economic reality. relying on them to guide a firms evolution usually results in institutional forms that are highly vulnerable to the removal of the market anomaly.

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Lesson 2 Evolution does not wait for industrial plans With surprising conformity, financial services firms continue to define strategic visions and annually updated five-year plans. The idea is to carry out appropriate analysis that points to the optimal destination a few years out. Many firms feel incomplete without this. They want to have both easily digestible soundbites and mountains of back-up information and research that capture and justify their grand strategic plans. One large bank recently estimated that its annual exercise costs 500 person-years. In an evolutionary world, however, sustained superior execution beats the best-laid strategies every time. your firm is in the middle of a journey and since the end of the journey is too uncertain to be meaningful evolving on the go is often the best strategy. Before describing some actions implied by this lesson, we must point out its most beneficial aspect. It avoids costly, and in some cases catastrophic, mistakes. Over the decades, the elaborate, aspirational strategy has frequently resulted in false destinations: retail banks trying to become global investment banks, wholesale banks becoming commodities traders, insurers becoming alternative asset managers with third-party clients and many firms becoming supermarkets. If they had been grounded in the reality of a natural evolutionary path, none of these expensive mistakes would have been made. to make the most of the journey, learning (copying if necessary) and adaptation are key. Continuous, stepwise innovations beat grand (re-)designs every time. That means finding the parts of your own businesses that provide real competitive advantage and learning from them how to perform better elsewhere. It means rewarding those that consistently deliver relative to market norms, rather than those that have great plans and presentations. Along the journey, your firm will meet new life forms. They will have a different DnA, different business cultures and different business models. Both behavioural adaptation and physical recombination can help you absorb their best features. In the financial world, it is astonishing that the same mistakes are repeated across different businesses, geographies and epochs. The lessons of past real estate crashes dont seem to have been learnt, for example, while poor distribution management is still prevalent in many european countries. On the journey, too, opportunities will present themselves some real and some illusory. the clever firm monetises these as it goes along but within a highly disciplined framework. trade buyers all missed the Long term Credit Bank of Japan, leaving a private equity firm to make a substantial return on it for its investors. More recently, Santander bought two businesses from ABn AMrO, selling one at a profit and hence acquiring an important asset in Brazil at no net cost.

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Lesson 3 Make yourself more attractive Both biological forms and financial services firms need the right type of resources to adapt sucessfully within their evolving environments. Financial services firms have to attract and retain human talent, capital, customers and technological assets. too many financial services firms have completely undifferentiated messages for these different resources: People are our most important asset; We run according to shareholder value principles; your call is important to us. Is your firm doing the right things to attract all three? talent, more than any other factor, has rightly come to the fore in recent years given that a stronger talent pool enables greater institutional adapativity. even a few decades ago, much of banking and insurance used to be slightly brighter shadows of sleepy administrative factories taking orders, processing them and doing the same again tomorrow. This has changed. Both encumbents and new entrants have seen the power of human ingenuity create whole new markets that did not exist before. Several key genes in the adaptive firm are associated with talent management: Is our leadership attracting or deterring the best? Do we have a culture that promotes all the other value drivers (innovation, adaptability, discipline)? Do we over-reward under-performers and under-recognise superior performers in the name of fairness? Do we know the alternatives open to our best people and what might motivate them to switch their energies? Capital is as indispensable as talent, but to be attractive to investors takes a different set of attributes. unfortunately, the governance of many financial services firms has drifted off course to the extent that management priorities are mainly focused on job preservation and reward maximisation rather than on shareholder value creation and, crucially, there is no effective corrective action from the board. With robust internal governance, the phenomenon of activist investors would not exist in its current, aggressive form. Is your firm welcoming to investors? Does your leadership think like capital? Or are you betting that capital is so plentiful that you dont need to justify what you do with it? Perhaps the most fickle and elusive of all business resources is the customer. Customers, too, have largely been neglected and even systematically mistreated by many financial services providers. The mis-selling scandals in developed countries, the pyramid schemes in emerging economies and generally low satisfaction rates among most retail customers speak for themselves. Instead of being wooed with better services and superior offers, customers are shackled by switching charges and captive products. Instead of being offered truly valuable solutions for their longer and more complicated lives, customers are often regarded as little more than a necessary evil. no wonder other species (direct/Internet innovators, retailers, telcos, software providers, healthcare and automotive companies) are invading the financial services market.

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Lesson 4 Habitats are more important than competitors In financial services, as in biological evolution, no-one can escape the environment that they are in. research has shown that financial services revenues are driven by two fundamental factors: exogenous economic production and endogenous innovation. The former is the key factor, accounting for over two-thirds of growth. In simple terms, higher GDP/capita, higher GDP growth rates and less equal wealth distribution are all big drivers of financial services revenues. Many other factors, such as regulation, play a role too. This creates a rich diversity of finance habitats, each with very different characteristics. A key insight from our research is that habitat differentials are more important than competitor pressures in most of financial services. Being present in the right markets is a big plus that can be managed over time. even seemingly monolithic markets (e.g. mass retail in a medium sized-economy) are actually composed of several sub-habitats, each with its own features. Large value skews are a persistent feature of most financial markets and should lead to a continuous hunt for the best habitats. There is ample evidence that much of the demand for financial services is latent and either goes un-served or appears as self-provision. Pension provision, insurance and risk diversification are very large areas of potential demand. By contrast, when new services have been made available often by initially small start-ups such as Capital One (credit cards), PayPal (payments) and MAn (retail hedge funds) the take-up has been very fast. Habitat loss is also a feature of the real world in finance. Cross-border payments in europe used to be a hugely lucrative business for commercial banks, but with the advent of the single market, this rent is disappearing fast. Structured products seemed like the no-brainer carry trade to those unfamiliar with the market, but the liquidity crisis of 2007 has clearly dealt a blow to that line of business.

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Lesson 5 Buy insurance everyone agrees that large exogenous shocks the economic equivalents of meteor strikes and ice ages will happen again in the future. Such shocks occur at a much higher rate than previously believed, simply because there are so many distributions in play. So-called six-sigma events actually occur every decade or so in some part of the financial system. there are two ways of buying insurance against such shocks. the first is the most obvious and least palatable for those locked into quarterly earnings announcements: Pay a premium to someone who will cover the extreme risks in your business portfolio. Most financial services firms in the world are not only aware of these risks, they quantify, monitor and report them regularly. Hedging such risks, however, has an immediate cost to the P&L and is often dismissed as too expensive. In our view, boards should be much more proactive in requiring the explicit hedging of specific extreme risks in their firms. Where this works, as in Goldman Sachs experience in the credit crunch of 2007, it can be spectacularly rewarding for shareholders and employees. The second type of insurance policy is to become amphibian. In some cases, a management team might suspect that it is the wrong species with the wrong genes and maybe the wrong habitat. The temptation in such situations is often to attempt to turn the firm into something that it is not: from a universal provider into a distribution powerhouse, from a mature economy provider to an emerging markets player, from a broker to a principal investor. Instead of committing such rash acts, it is possible to grow capabilities that are still linked to the core of the firm but create new growth options. Credit card firms need to find cheaper, more stable customer deposits. Domestic retail banks need to build a platform that is better for their customers and that can go cross-border. Life insurers need to tap into the savings wallet of their clients. Having lungs and gills can be a great insurance policy as liquidity ebbs and flows.

The above is not a formulaic recipe that, if followed to the letter, will create the financial services equivalent of homo sapiens at the top of the evolutionary tree. Indeed, a lesson from evolution is that every survival strategy has its own extinction buried deep inside it. rather, the above lessons are internally consistent guidelines for leaders who face a barrage of often conflicting advice and demands. Boards, CeOs and executive management teams who swim with the evolutionary tide are more likely to survive and thrive.

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oVerVieW evolution is not just a metaphor for the state of financial services, but an internally consistent set of processes that can be seen at work in markets past and present. It is the only plausible framework that describes the many sometimes seemingly contradictory aspects of the financial world over long periods. Most of the consensus view has been shown to fall short when it comes to providing future guidance, mainly because its past reference period is too short and its assumed futures are too smooth. With all the important drivers of financial services growth, from macroeconomics to demography to innovation, the next quarter-century will not be a linear extrapolation of the last one. Indeed, the biggest drivers of all BrIC expansion, risk transfer and high liquidity will likely experience the highest volatility.

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COnCLuDInG reMArKS

examining the history of financial services and the macroeconomic conditions in which the industry operates yields some important insights into the current state of the industry. In certain dimensions we are little (if at all) more advanced than we were at the beginning of the twentieth century, while on other measures we are truly in uncharted waters. In terms of global integration and liquidity, for example, the world is essentially repeating the experience of Globalisation 1.0 before 1914. In terms of securitisation and the use of derivatives, on the other hand, we really are in a new world. The key to survival for any financial services firm lies in the ability to recognise the slowly evolving long-term trends at work, while at the same time preparing for the inevitable and unpredictable shocks that will occasionally strike. Long-term trends can be as slow-moving and predictable as demographic shifts in the developed world and growth in emerging Asia. It is harder to predict when crises will come, however, and what form they will take. Only the best prepared firms will weather the storms ahead without lasting damage. Constant vigilance and adaptability are the keys to survival. Those that successfully recognise the difference between the periodic winters (financial crises, bear markets and periods of low liquidity) and the epoch-defining ice ages (Great Depressions and inflations) will be those that succeed. every shock to the financial system will result in casualties. For a short period, natural selection will work fast to eliminate the weakest institutions in the market, which will typically be absorbed by the successful. Most crises will also usher in new rules, as legislators and regulators react and politicians mark their ground by acting to protect the consumer. The critical point, however, is that this possibility of extinction cannot and should not be removed by excessively precautionary regulation. As Joseph Schumpeter wrote more than seventy years ago, This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted. Creative destruction means nothing less than the disappearance of those firms which are unfit to live.22 Although there is much more research to be done on the long-run evolution of modern finance, we have no doubt that Schumpeters words remain applicable today.

22 Schumpeter (134), pp. 254

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ACKnOWLeDGMentS
Oliver Wyman is a leader in financial services strategy and risk management consulting. The breadth and depth of our work in financial services gives us deep insight into the issues our clients face and how to help them perform better. to complement this, we also harness the varied experience of our Senior Advisory Board members all with distinguished careers as regulators, chief executives and academics to enhance the pragmatic impact of our leading-edge ideas. The members of the Oliver Wyman Senior Advisory Board are Rolf E. Breuer, former Chairman of the Supervisory Board and Chief executive of Deutsche Bank Mathis Cabiallavetta, vice chairman of Marsh & McLennan Companies, Inc., former chairman of the board of uBS Henning Christophersen, former Danish Minister of Finance and eu Commissioner Carlo Corradini, Chairman of Leonardo Italy, and member of the Board of Directors of Banca IMI Professor Niall Ferguson, Harvard university, author of The House of rothschild and The Cash nexus Korkmaz Ilkorur, Founder of lkorur Advisory Services and chairman of Bati Insurance Company Alexander Hendrik George Rinnooy Kan, Chairman of the Social and economic Council of the netherlands (Ser) and Member of the executive Board for InG Group Sir Andrew Large, former Deputy Governor, Bank of england David Murray, former Chief executive of Commonwealth Bank of Australia Emmanuel Rodocanachi, Chairman of the Supervisory Board of Salomon Smith Barney, formerly Chairman and Chief executive Officer of natexis SA Vanni Treves, Chairman of the Board of Korn/Ferry International, The equitable Life Assurance Society, Intertek Group Plc and the national College of School Leadership Ignacio Sanchez- Asiain Sanz vice Chairman of Banco Provincial, BBvA Chile, Banco Continental and BBvA Colombia Charles N. Bralver, executive Director of the Master of International Business program and Center for emerging Markets enterprises, at The Fletcher School of tufts university and founding partner, Oliver, Wyman & Company

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profeSSor NiAll ferGUSoN niall Ferguson is Laurence A. tisch, Professor of History at Harvard university and William Zeigler Professor of Business Administration at Harvard Business School. He is also a Senior research Fellow at Jesus College, Oxford university, and a Senior Fellow at the Hoover Institution, Stanford university. His numerous books include The Worlds Banker: The History of the House of Rothschild, which won the Wadsworth Prize for Business History, and The Cash Nexus: Money and Power in the Modern World, 1700-2000, which he wrote as a Houblon-norman Fellow at the Bank of england. A prolific commentator on contemporary politics and economics, niall Ferguson is also a contributing editor for the Financial Times.

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