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Confluentia endeavours to supply our clients
with periodic updates and insights relating
to project practices and issues, the market,
and financial technology.
Confluentia - Market & Project Update
Highlights
2008 was a year in which only landscape-changing events could expect to make it to a "highlight" list. In the year book-ended by Jerome Kerviel's EUR 4.9 billion losses at Soc Gen, and Bernie Madoff's unprecedented USD 50 billion fraud, here are some such events:
- The nationalization of Northern Rock, Fannie Mae and Freddie Mac
- The partial nationalization of Lloyds, HBOS (Halifax Bank of Scotland) and RBS (Royal Bank
of Scotland) - The shuttering under various guises of Bear, Lehman, Wachovia, and Washington Mutual
- The extinction of the US investment bank, as Goldman Sachs and Morgan Stanley became commercial banks to ensure access to liquidity from the US Federal Reserve
- The weekend buyout of Merrill Lynch by Bank of America
- The USD 85 billion lifeline thrown to AIG (American International Group)
Other statistics:
- USD 320 billion was withdrawn from mutual funds
- Oil broke $100 per barrel in January 2008, climbed to $147 in July, and dropped again to the
mid-30s in December, wreaking havoc with the carbon markets - The US's FDIC (Federal Deposit Insurance Corporation) problem bank list grew from 90 at the end of
Q1 2008 to 252 by the end of the year, with 25 banks shut down during the year (and
a further 14 already shut to date in 2009) - The Dow Jones Industrial Average fell 18.2% in the week of October 6 - its worst ever one-week decline
- London's FTSE 100 lost 21.1% in the same week as investors scrambled to move into cash
- The financial sector incurred more than 113,000 job losses.
2008 Summary
The focus was on shoring up capital, liquidating positions, plumbing derelict corners of the balance sheet to pledge or securitize collateral for cash, and scrambling to confirm and reduce exposures to troubled counterparties. Short-term funding is still a critical issue, with central banks remaining essential providers of liquidity via initiatives such as the US Federal Reserve's CPFF program. While we may be nearing the bottom from a financial-sector perspective, the situation remains critical, with Citibank and Bank of America stocks tumbling as nationalization fears increase.
Solving the Crisis
Shoring up banks' capital is essential, but as events have demonstrated, that alone will not restore the health and fluidity of the credit markets. The about-to-launch US TALF program (Term Asset-Backed Securities Loan Facility) offers one hope for relieving cash-strapped companies while restoring some trust in securitization and financial intermediation. Toxic assets still have to be addressed at certain firms, however: in the US the renegotiation of sub-prime mortgages may go some way to ascertaining the correct pricing. In certain cases temporary bank nationalization appears preferable, as an outcome of the stress tests currently underway, to the alternative: saddling taxpayers with debt without a demonstrable return on investment. Nationalization has been successful in the UK and, historically, in Sweden, and even in the US where nationalization is considered by some a four-letter word, the FDIC has been doing essentially that, albeit with smaller banks.
On the level of the broader economy, government capital has to be injected to compensate for the retrenchment in consumer spending, and ideally this should come in the form of concrete spending such as infrastructure projects, renewable energy projects, or orders for fleets of green vehicles. Bloated defense budgets are prime candidates for significant reductions as a means of minimizing the deficit increases that will result.
On a global level, economies with a trade and savings surplus such as China should be encouraged, at least temporarily, to spend more, stimulating production and generating cash-flow in the deficit countries such as the US and UK.
Looking forward - preventative measures
Avoiding a repeat - the human element
Although the landscape continues to change as the crisis unravels, at a certain point we will
be through it, getting familiar with the new and remaining players, and attempting to look ahead.
At that point, what measures can be taken to prevent a repeat? The Counterparty Risk Management Policy Group III report on containing systemic risk (by Gerald Corrigan, co-chair of the CRMPG, currently at Goldman Sachs, and a former head of the New York Federal Reserve), published in August 2008, outlined a number of valuable proposals. The report emphasized the human element as irreplaceable in risk management, cautioning against excessive and exclusive reliance on quantitative risk metrics. It recognized the importance of scenario analyses and stress tests, but recommended that firms periodically perform cross-functional brainstorming on potential contagion hotspots. Running the prior two years of market data and the odd curve bump against one's portfolio only achieves so much in a protracted period of low interest-rates and inflated security values. The report also proposed that the highest level supervisory bodies meet at least annually with board of directors of large financial institutions to convey their views on the institution's stability and its capacity to handle adversity, as a means of helping boards better perform their oversight function.
Derivative matching and buyside limitations
Among the report's more immediately tangible recommendations were trade date (T0) matching on electronic transactions, and greater linkage of confirmation and settlements. Another recommendation was moving towards a central counterparty for OTC derivatives, an initiative that is gathering momentum in the US and Europe. Other recommendations included restricting trading volumes with buyside institutions that could not demonstrate sufficient automation, and the stipulation that investors have access to adequate valuation and risk-measurement tools for complex financial products before being permitted to purchase them.
Derivatives and securitization
Those proposals would go some way to addressing concerns around derivatives and securitization, two of the leading scapegoats of the crisis in non-financial circles. Both product categories are important tools in the financial markets, and so any solution must involve greater regulation of them rather than eliminating them altogether. Derivatives are essential hedging tools and are also perform an important function in forward price formation. Likewise, it is impossible for banks, even when the sector is healthy, to finance the entire economy with their balance sheets, so securitization in some form is essential.
Project work
Large-scale strategic IT projects were few and far between in 2008. Smaller-scale, targeted initiatives continue, however, along with essential projects to support acquisitions.
Below is a short summary of the types of initiatives we are likely to see.
Counterparty exposure
Large financial institutions should be able to automatically compile, within hours, risk concentrations across asset classes and estimates of exposure to institutional counterparties, based on the prior day's close (CRMPG recommendation). Operations and risk management staff were stretched thin in 2008 attempting to compile such information manually, and the means to perform such consolidation automatically is sorely needed. Information should not just be at the primary counterparty level, but should be able to identify exposures within indices, securitized products, and syndicated deals.
Collateral management
Accurate, cross-product collateral reporting is needed to facilitate having a current view of whether margin calls are needed or when limits have been breached. It is critical that such reporting be consolidated across product silos, and that transactions and positions have current valuations.
T0 matching and linkage of confirmations and settlements
As mentioned above, there is now even greater impetus for trade date (T0) matching on electronic transactions, and greater linkage of confirmation and settlements. The CRMPG recommended that such straight-through processing be implemented by the end of 2009.
Central clearing of OTC Derivatives
Also as mentioned above, systems projects will be needed to plumb interfaces between banks and the central clearing platforms that are established for the CDS market.
US Accounting Standards
The wheels are in motion for the US to move from US GAAP (generally accepted accounting principles) to IFRS - International Financial Reporting Standards. The period for questions has just been extended, but once a regulatory roadmap has been laid out, significant work will be needed to modify systems to support the new accounting rules, and some banks may choose to leverage the opportunity to achieve greater alignment across their global accounting platforms.
Integration projects
Perhaps the biggest projects in 2009 are likely to be those that stem from acquisitions: bolting two banks' systems together, or getting assets off one bank's systems and onto another's. Such projects are immensely complex and touch all areas of the bank, encompassing large-scale systems integration work, legal documentation modifications, HR considerations, and credit, compliance, tax, and regulatory reviews, all of which need to be maintained on a tight schedule. On the systems side, the analysis would typically involve evaluating whose software platforms to use for each product and function, and enhancements to build out the target platform to accommodate nuances of the new portfolio. The trade and position migrations are large chunks of work in themselves, with all the end-to-end reconciliations that are needed. One area that can cause significant challenges is client data: reconciling client lists, validating credit limits, performing KYC, and informing clients of upcoming trade migrations.
Wrap up
Confluentia anticipates a challenging year for most participants as they adjust to new realities
and consolidate their new business models and any bolt-ons. Credit is likely to remain tight, as real-economy job losses continue to impact corporate cashflow and creditworthiness. We do expect some lift in the second half of 2009, however, although the sector and the broader economy is likely to remain retrenched well into 2010.
Without doubt we are living and working through the most severe financial crisis in generations, and will emerge with a fresh appreciation for depression-era cautions about living within one's means and avoiding excessive leverage. Time will tell whether broader, more permanent change ensues, however, especially on fronts such as executive compensation: although the income gap has recently reached levels only paralleled by the pre-crash 1920s, memories are short. Our optimistic side hopes that a more equitable economy will emerge, while one that still rewards hard work and the discerning taking of risk.
About Confluentia Group
Confluentia is a boutique capital-markets consulting and technology firm with front-to-back expertise across multiple product areas. Our specialty is providing top calibre business analysts, project managers, and technologists to design and deliver systems and projects.