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Confluentia endeavours to supply our clients
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Confluentia - Market & Project Update
This month we are very glad to be issuing our first edition of the Confluentia newsletter. We hope that our newsletters will help you keep abreast of what's happening in capital markets, with a particular emphasis on projects and technology.
Liquidity has become the hot topic, with treasurers and risk managers - in both the banking and corporate sectors - currently being leading influencers of business decisions and strategy. Major rights-issues are now an almost monthly occurrence, eclipsing US $110 billion since late 2007, with capital ratios being reduced to concerning levels due to a combination of outright losses and paper losses due to liquidity-constrained prices.
Job losses have resulted not just directly from the closure of many sub-prime and credit-related businesses, but also indirectly as banks look to trim their expenses in an attempt to reduce the effect on their earnings and ease downward pressure on their share prices. While the tide of job losses have been somewhat under the media radar, in the past 12 months a staggering 83,000 financial-sector jobs have gone by the wayside.
Although the scale of the write-downs and the players initially kept the headlines focused on the financial sector, the real-world economy is now front-and-center, with US home foreclosures doubling to 1,300,000 from 2006 to 2007, inflation on the rise, and oil and food price increases having direct adverse effects on many individuals and companies around the world.
The upside
In such an environment, what positive aspects can be noted for capital markets? The short-term outlook undoubtedly remains grim, perhaps neutral at best. The medium-term outlook, meanwhile, is less dependent on skilful management by investment bankers alone - although steps are being taken to restructure many deal types - than it is on the interplay between bankers, governments, and central banks as they attempt to navigate inflationary pressure and fiscal policy.
Taking a forward-looking view, however, and without intending to be comprehensive, the following points may be noted:
- First, banks still have and attract some of the brightest financial minds and best information-technologists.
- Second, the significant capital investments in European and US banks from sovereign wealth funds in the Middle East and Asia can be regarded as forerunners of the massive sums that will increasingly be seeking a return in the global market-and likewise that will be required to fuel entrepreneurialism at home-as the developing economies' multitudinous workforces continue their gradual ascent into relative prosperity.
- Third, global warming is increasingly forcing the hand of the market towards alternative energy and carbon trading, both of which are likely to become significant markets in their own right. In Europe the carbon cap-and-trade market is now well established, and the US is taking steps to catch up. Already the US is pressing forward at the regional level, with the launch of the RGGI ("ReGGIe," the Regional Greenhouse Gas Initiative) carbon cap-and-trade system on January 1, 2009. And although the US's recent Lieberman-Warner bill-which included a carbon cap-and-trade proposal-did not make it to a vote, encouragingly the debate largely centered on the economic consequences of the bill for senators' constituents, rather than on whether human activity was causing climate change. That augurs well for a federal carbon cap-and-trade system in the next presidential administration.
Given those sample variables alone - banks having the human talent, the emergence of capital and opportunities in new regions, and the emergence of new markets - there is still good reason to be positive about capital markets when taking a longer-term view. On a human level it is also encouraging to think that capital markets can become primary actors in the macro-level challenge of stabilizing the planet's atmospheric deterioration, while indirectly reducing energy dependence and thus contributing to greater peace and stability.
Project View
Given the environment, what does Confluentia see as the main project needs in capital markets at present and in the near-term?
1. Straight-Through Processing (STP) and Back- and Middle-Office controls
Gone, at least for now, are the heady days of front-office pressing forward into bull markets and complex, customized trades without a robust back-end risk-monitoring solutions in place. Excel and Access tools have their merits, but regulators and auditors have always taken a dim view of manual and semi-manual processes that lack appropriate controls and oversight: for some banks and desks it has taken a bear market to help demonstrate why.
Robust, IT-supported systems; straight-through processing (STP) to settlements, risk systems, and accounting; STP to market-wide confirmation- and settlement-matching solutions such as DTCC, including automated derivative-novation processing; cross-business visibility of market risk, funding needs, and counterparty exposure; the ability to drill down to the asset level and explain risk and P&L-these are the types of projects that are taking priority.
An informal industry survey confirms this, indicating that, in the next 12 months, back-office projects will account for more than 50% of banks' IT spending. Another survey further illustrates that banks know that they cannot afford to slash IT and project budgets, despite the current slow-down: it estimates that banks will only spend 5% less on IT projects in 2008 than they did in 2007.
As a sidenote, although sponsors of such projects often envision headcount reduction as an outcome, the savings often come in different ways: the project typically lays a robust foundation for businesses to scale while keeping backoffice headcount stable; and turnover-related expense is reduced due to greater work satisfaction as tasks are transformed from a clerical orientation to an analytical one.
2. Silo rationalization and streamlining workflow
The above types of STP initiatives require not just "vertical" silo-oriented work, but horizontal work too, to ensure that the risk and assets from different desks can be readily consolidated and monitored, and likewise to reduce operational risk by consolidating multiple back-office-processing silos into single, firm-wide ones, at minimum on a regional basis, and ideally globally.
While such projects make sense within any medium or large bank having multiple desks and businesses, they are not always pursued in lean times. Even in a budget-constrained environment, however, such projects typically rise to mandatory status in a post-acquisition environment. The recent spate of acquisitions - Countrywide and LaSalle by Bank of America, ABN AMRO by the RBS-led Royal-Fortis-Santander consortium, Bank of America's equity prime-brokerage division by BNP Paribas, and Bear Stearns by JP Morgan - are examples of scenarios where this type of work becomes essential.
Such projects don't just require staff with good product knowledge, technology awareness, project-management skills, and analytical skills. Given the job insecurity that is prevalent in an acquisition environment, such projects also require people who can constructively attune to the interpersonal side of what is going on, building (and not squandering) trust, recognizing and airing concerns, and navigating all parties towards common objectives.
3. Regulatory work
While not yet looming as a short-term need, the sub-prime fallout is likely to include several major overhauls to the regulatory environment that will require project work over the coming years.
In the hedge-fund sector, a set of best practices were published by UK and US working groups in January and April 2008, respectively. The best practices covered five main areas: disclosure; valuation; risk management; trading and business operations; and compliance, conflicts and business practices. In the absence of regulation, the more progressive funds are voluntarily embarking on projects aimed at providing greater transparency and accountability, as they strive to shore up risk management, operational control and disclosure amid a storm of market-loss-related redemptions.
Meanwhile in the investment banking and brokerage sector, in March the US Treasury released a regulatory-overhaul proposal. While dismissed by some commentators as a superficial changing of hats, the proposal is certain to generate some modifications to regulatory-reporting needs over the coming years. Examples include, in the short-term, creating a Mortgage Origination Commission and, with time, bringing oversight of futures, securities, insurance, and banking under a common umbrella. The proposal also called for an approach that is more principles-based rather than rules-based, in line with the approach of the UK's FSA. The new framework would encompass not just financial regulation, but also the maintenance of market stability and the regulation of business conduct. Such a move would represent one of the first major regulatory overhauls of the US financial sector in 80 years, and will hopefully result in a more harmonized, cohesive regulatory 'organism' that inspires greater market and investor confidence and assures a steady in-flow of domestic and international capital.
Summary View
The financial sector is currently undeniably in contraction, with significant liquidity, capital, and inflationary concerns. Provided, however, that all the relevant financial, governmental, and regulatory actors move with discernment and decisiveness over the medium term, we at Confluentia have an optimistic medium- to long-term outlook for the sector, with all the exciting business, technological, human, and even environmental challenges that the future will inevitably hold.