The Future of Finance E-Book

Moorad Choudhry

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 331

Veröffentlichungsjahr: 2010

Beschreibung

New banking and investment business models to navigate the post-financial crisis environment The financial crisis of 2007-2008 has discredited business models in the banking and fund management industries. In The Future of Finance, Moorad Choudhry and Gino Landuyt argue that banks must realign their business models, implying a lower return-on-equity; diversifying their funding sources; and increasing liquidity reserves. On the investment side, the authors discuss how diversification did not reduce risk, but rather amplified it, and failed to stabilize returns. The authors conclude that the clear lesson from the crisis is to know one's risk. A lesson that is best served by concentrating on assets and sectors that you understand. * Examines the weaknesses in the business models of many institutions, as well as the theoretical foundation for professionals in the field of finance * Identifies the shortcomings of Modern Portfolio Theory * Addresses how investment managers can find new strategies for creating "alpha" and why they need to re-vamp their fee structures Filled with in-depth insights and practical advice, The Future of Finance will provide bankers and investment managers with a guide to realigning their businesses in order to prosper in the post-crisis financial markets.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Foreword

Preface

Epigraph

Introduction

MARKET INSTABILITY

DERIVATIVES AND MATHEMATICAL MODELING

SENIOR MANAGEMENT AND STAYING IN THE GAME

MACROPRUDENTIAL FINANCIAL REGULATION AND CYCLE-PROOF REGULATION

THE WAY FORWARD

CONCLUSION

PART ONE - A Review of the Financial Crash

CHAPTER 1 - Globalization, Emerging Markets, and the Savings Glut

GLOBALIZATION

A SERIES OF EMERGING-MARKET CRISES

LOW-YIELD ENVIRONMENT DUE TO NEW PLAYERS IN THE FINANCIAL MARKETS

ARTIFICIALLY LOW EXCHANGE RATES

RECOMMENDATIONS AND SOLUTIONS FOR GLOBAL IMBALANCES

CHAPTER 2 - The Rise of Derivatives and Systemic Risk

SYSTEMIC RISK

DERIVATIVE MARKET SYSTEMIC RISK: SOLUTIONS FOR IMPROVEMENT

CHAPTER 3 - The Too-Big-to-Fail Bank, Moral Hazard, and Macroprudential Regulation

BANKS AND MORAL HAZARD

ADDRESSING TOO-BIG-TO-FAIL: MITIGATING MORAL HAZARD RISK

MACROPRUDENTIAL REGULATION: REGULATING BANK SYSTEMIC RISK

CONCLUSION

CHAPTER 4 - Corporate Governance and Remuneration in the Banking Industry

BONUSES AND A MORAL DILEMMA

A DISTORTED REMUNERATION MODEL

UNSUITABLE PERSONAL BEHAVIOR

CONCLUSION

CHAPTER 5 - Bank Capital Safeguards: Additional Capital Buffers and Reverse Convertibles

CAPITAL ISSUES IN A BEAR MARKET

LOOKING FOR NEW CAPITAL INSTRUMENTS

CHAPTER 6 - Economic Theories under Attack

A BELIEF IN FREE AND SELF-ADJUSTING MARKETS

MODIGLIANI AND MILLER

MARKOWITZ AND DIVERSIFICATION TESTED

MINSKY ONCE AGAIN

LESSONS TO BE LEARNED BY CENTRAL BANKS

CONCLUSION

PART TWO - New Models for Banking and Investment

CHAPTER 7 - Long-Term Sustainable Investment Guidelines

THE INVESTMENT LANDSCAPE AFTER THE CRISIS

GOVERNMENT DEBT AND DEMOGRAPHICS

A NEW ECONOMIC ENVIRONMENT

THE INFLATION DRAGON

CURRENCIES AND A CHANGING GEOPOLITICAL LANDSCAPE

EXCHANGE-TRADED FUNDS: A FLEXIBLE ASSET CLASS

CONCLUSION

CHAPTER 8 - Bank Asset-Liability and Liquidity Risk Management

BASIC CONCEPTS OF BANK ASSET-LIABILITY MANAGEMENT

ASSET AND LIABILITY MANAGEMENT: THE ALCO

ALCO REPORTING

PRINCIPLES OF BANKING LIQUIDITY RISK MANAGEMENT

MEASURING BANK LIQUIDITY RISK: KEY METRICS

INTERNAL FUNDING RATE POLICY

CONCLUSION

CHAPTER 9 - A Sustainable Bank Business Model: Capital, Liquidity, and Leverage

THE NEW BANK BUSINESS MODEL

CORPORATE GOVERNANCE

LIQUIDITY RISK MANAGEMENT

THE LIQUID ASSET BUFFER

CONCLUSIONS

Notes

References

About the Authors

Index

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Copyright © 2010 by Moorad Choudhry and Gino Landuyt. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Author’s Disclaimer: This book does not constitute investment advice and its contents should not be construed as such. The contents should not be considered as a recommendation to deal and the authors do not accept liability for actions resulting from a reading of any material in this book.

While every effort has been made to ensure accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this book can be accepted by the authors, publisher, or any named person or corporate entity.

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Library of Congress Cataloging-in-Publication Data:

Choudhry, Moorad.

The future of finance : a new model for banking and investment / Moorad Choudhry, Gino Landuyt. p. cm. - (Wiley finance series)

Includes bibliographical references and index.

ISBN 978-0-470-57229-0

1. Banks and banking. 2. Portfolio management. 3. Risk. 4. Investments. 5. Global Financial Crisis, 2008-2009. I. Landuyt, Gino. II. Title.

HG1573.C44 2010

332.1-dc22

2010018129

Dedicated to the spirit of John Lennon, Paul McCartney, George Harrison, and Ringo Starr—masters in the pursuit of excellence.

—Moorad Choudhry

In loving memory of my grandmother (June 21, 1915-May 1, 2009)

—Gino Landuyt

Foreword

Economic and financial crashes are nothing new. Students of finance will be familiar with the pattern of crises that has beset markets since the 1700s. However, the crisis of 2007-2009 was unique in certain respects. First, it took place in an era of globalization, with its consequent almost instantaneous transmission of events. Second, it followed no set pattern. There was no initial shock followed by recovery; rather, economies and markets were beset by a series of shocks, each of greater impact than the last. Thus, the initial events—the crisis in the U.S. subprime residential mortgage market, the losses at two Bear Stearns hedge funds, the illiquidity in the asset-backed commercial paper market, the run on the UK bank Northern Rock—led seemingly to a still greater crisis, culminating in the bankruptcy of Lehman Brothers and the government bailout of the insurance giant American Insurance Group (AIG). It was at this point that governments in the United States and Europe had to step in and save their banking sectors from imminent collapse. The crisis of 2007-2009 differed from previous market corrections in that for a time there appeared to be no end in sight for it.

The near failure of the banking system and the worldwide recession that followed provoked considerable debate on how it had been allowed to happen, and what steps should be taken to reduce the likelihood of another crash and, if such a crash should occur, how to mitigate taxpayer exposure. It was evident that egregious errors had been made in bank governance, regulatory policy, and risk management regimes. The diversity of firms impacted by the crash, however, suggests there is no simple, universal cure for the financial markets. Banks and investors are better advised to learn the lessons of the crash and adopt policies and processes that mitigate the effects of the next crash, rather than think that they can avoid its impact altogether.

The financial crash and its aftermath have already been covered extensively in the literature. Academics, practitioners, and journalists have provided the market with numerous treatises and analyses, some of it polemic in nature and all too often offering little added value. Wisdom in hindsight is abundant. When we remember that John Kenneth Galbraith’s seminal study of the 1929 stock market crash was published 25 years after the event, it is clear that the lessons to be learned from the latest crash will take some time to formulate and digest; much of the material published so far on the crash suffers from being written in haste, and that brings me to this present work by Moorad Choudhry and Gino Landuyt. The authors have benefited from taking a longer term perspective at the causal factors behind the crash, and this has paid off in the value and tractability of their policy recommendations. They point out the paradox of financial markets: unlike many other asset types, an increase in financial asset prices leads to increasing demand. A proper understanding of the markets, and how to position oneself for changes in conditions throughout the economic cycle, will serve bank boards and investors best.

Another lesson of the crisis, which Messrs. Choudhry and Landuyt point out, is that market stability itself plants the seeds of the next crisis. In an environment of stable interest rates, low inflation, and economic growth, banks and leveraged investors extend their risk-reward frontiers and take on more debt. This makes sense if one makes an implicit assumption that growth will be continuous, and that asset prices will only move upwards. But to make this assumption is to be unprepared for the inevitable downturn. The paradox of stable markets needs to be built in to any practical implementation of efficient market theory and modern portfolio theory. The authors review the conundrums at hand, and list practical steps that investors can take in their approach to more efficient fund management. The crisis of 2008 was also a crisis in bank liquidity; helpfully, this book reviews liquidity policy and how banks can set up a more effective liquidity risk management infrastructure.

I have known and worked with Dr. Choudhry for ten years, and it is a pleasure to write this Foreword. Investors will find much valuable insight in this succinct and accessible book, as well as recommendations of practical import to take with them into the changed, more risk-averse era of finance.

Frank J. FabozziProfessor in the Practice of Finance, Yale School of Management Editor, Journal of Portfolio ManagementJuly 2010

Preface

The year 2008 was an annus horribilis for investors in financial markets. No investor was protected against the downfall in asset prices. Even the stars of the past decade, the wizards of Greenwich who promised that investment portfolios would be made immune to downward correction by adding portable alpha to their portfolios, had to admit that there was no safe haven. Diversification across several different asset classes didn’t work either, since every major asset class appeared to be under attack.

What the 2007-2009 credit crunch and economic recession reminded us was that diversification and the efficient portfolio theory do not apply at all times. What is apparent is that a cornerstone of modern finance, the modern portfolio theory (MPT), did not withstand the test during the financial market crisis of 2007-2008. Moreover, in a bear market it can be observed that diversification to hedge or spread risk sometimes destroys value rather than creates it, because it merely magnifies the existing risk exposure for no further reward.

Consider the Credit Suisse/Tremont Hedge Fund Index returns in Table P.1 (also shown in Chapter 6 as Table 6.1). All the strategies shown (except for dedicated shorts and managed futures) reported a negative performance for 2008. We can argue that both dedicated shorts and managed futures are pure directional plays, like betting in a casino, and anticipate a negative downturn, and so would always perform positively in a bearish environment. These two strategies cannot be said to represent the application of MPT.

The problem is that MPT and the diversification argument, like so many good investment ideas, only work in a bull market, when investors pay at least lip service to “fundamentals” and attempt to apply some logic in share valuation. In a bear market, or in any period of negative sentiment, all asset prices and markets go down. And in times of crises, as we have observed during 2007-2008, correlation between asset classes is practically unity.

It does not matter what industry, country, or level of managerial expertise is being considered; all prices go down and all credit spreads widen in a bear market such as the one we experienced in the recent crisis. In that crisis, everyone lost money: banks, hedge funds, volatility traders, private equity, long/short investors, and traditional long-only fund managers all registered losses.1 More significantly, if we look closer at the Credit Suisse/ Tremont Index we notice that even the long/short equity index is down in this period as well, by over 30 percent. This refutes the claim that these strategies generated alpha.

TABLE P.1 Credit Suisse/Tremont Hedge Fund Index Performance 2008

Source: Credit Suisse/Tremont Hedge Funds Index. Reproduced with permission.

On paper, diversification principles carry elegance and neatness but where modern portfolio theory suffers the greatest weakness is in its assumption that in every market, correlation is below 1.00. What we have observed over the past five years, whether it is managed on the basis of fundamental factors, momentum, arbitrage, or any other rationale, is that everything tends to end up on the same side of the trade at the same time. Believers in portfolio theory are convinced that (for instance) alternative investments are somehow negatively correlated with basic equities. During 2007-2008 they learned the hard way that this was simply not true. Bonds, equities, commodities, and currencies aren’t asset classes in their own right.

The same argument applies to banks that diversified by branching out and operating globally. The rationale was that moving into different geographical regions spread and diversified risk. In fact all this did was magnify risk across economies so that when the credit crunch came it hit them everywhere. While the ultimate global bank, HSBC, weathered the storm fairly well despite its geographical dispersion, due largely to its conservative liquidity management policy and strong capital base, some of the largest losses, in relative terms, occurred at global banks such as Citibank, RBS, and UBS.

The efficient market hypothesis and MPT clearly had their merits over the past 35 years. They were the basis for an investment and banking model that generated significant returns from the 1980s onward. However, in a severe bear market this philosophy has been seen to be flawed, and contributed to the development of a banking business model that suffered large losses. The inaccurate assumptions on which it is based suggest that a paradigm shift in economics needs to take place that modifies or completely replaces MPT. Portfolio diversification only makes sense if one has the possibility of picking out assets which are uncorrelated. Unfortunately, in a severe recessionary environment, correlation tends to go to one within every asset class, so this is a nonstarter for anything other than a short-term (less than five-year) investment horizon.

Our suggestion is that the paradigm shift in financial economics should be a reversion to traditional markets. Not only does diversifying across asset classes and geographical regions not spread risk, in a bear market it actually amplifies risk. The clear lesson from the crisis is to know one’s risk, and that is best done by concentrating on assets and sectors that one is familiar with. Diversifying in the name of the MPT will only erode value.

Some of our policy recommendations include the advice to:

• Restructure the business model to assets and regions in which one has genuine understanding and expertise.

• For banks, secure long-term liquidity to allow for times of market corrections and illiquidity. We further recommend avoiding overleveraging on the capital base.

These and other recommendations are explored in detail in Part Two of this book. In essence, we hope to demonstrate our belief that a paradigm shift that results in a greater concentration on familiarity and an acceptance of lower average returns will do much to prevent large-scale losses at the time of the next market correction.

This book reviews the causes and consequences of the financial market crash of 2007-2009, and presents recommendations on how to create a more sustainable bank and investment model for the future. Specifically, we look at how banks should be structured and governed, particularly with regard to their liquidity risk management and board corporate governance, and at a set of investment guidelines that would be least susceptible to the next market crash. Highlights of Part One of the book include a wide-ranging review of the causes of the financial crash, and note that many of the causal factors behind it remain in place. Part Two of the book presents our recommendations for a revised model for both banking and principles of investment, which we believe, if followed, will produce a more sustainable business environment.

Crashes of one sort or another are an integral part of the free-market economy. Rather than trying to prevent them or, worse still, thinking that they can be avoided or legislated away, it behooves financial market practitioners and regulators to place themselves and the firms in which they work in a position where they suffer least from the impact of crashes when they do occur. We believe that implementing some of the recommendations in this book will assist firms to achieve this goal.

Moorad Choudhry Surrey, England April 2010

Gino Landuyt London, England April 2010

The spread of secondary and tertiary education has created a large population of people, often with well-developed literary and scholarly tastes, who have been educated far beyond their capacity to undertake analytical thought.

—Peter Medawar, quoted in R. Dawkins,The Greatest Show on Earth:The Evidence for Evolution (London: Bantam Press, 2009)

Introduction

The financial markets have always been plagued by crises and bubbles of one sort or another. Students of economic history will be familiar with the South Sea Bubble, the Dutch Tulip Bubble, and the Wall Street crash of 1929, as well as more recent events such as the 1997 Asian currency crisis and the 1998 bailout by the U.S. Federal Reserve of the hedge fund Long Term Capital Management (LTCM). Crashes are nothing new and, far from being viewed as something rare or odd, should instead be viewed as the norm, and inherent to the nature of free markets. Finance has always suffered from crises, and this is true irrespective of whether the financial system in place is open or closed, simple or sophisticated.