The emotional reaction from Robert Albertson, principal and chief strategist at US boutique investment bank Sandler O'Neill and former head of bank research at Goldman Sachs, is typical of many bankers. "Your thesis is too extreme; I know of no time in history when the markets [have not recovered]. What I'm seeing is the beginning of a strong recovery from private equity funds, with at least $150bn of private equity [out there], which with leverage translates into $700bn [looking for investment]," he says, in answer to The Banker's suggestion of a potential 10-year bear market.
The post-Iraq scenario that the majority of banks and commentators envisage involves a modest US-led economic and stock market recovery within the next 18 months. The problem is that the desire for an upturn is being confused with the reality of one.
What happens if strategists and investors are wrong when they talk of conditions being ripe for a rebound, of the markets bottoming out and of buying opportunities? A 10-year bear market would have profound implications for banks, closing off avenues of growth and leading to a reassessment of their basic strategies. "If the market is dead for a decade, then investment banking is dead for a decade," Mr Albertson admits.
At first sight, the worst hit would be investment banks. But on closer inspection, the outcome for retail and commercial banks would be brutal because of a host of other circumstances, including capital-raising difficulties, the need for continual cost cutting, problems with pension schemes and ruptures in fundamental businesses, such as asset management.
Markets have been at their most volatile for years in the first quarter. The FTSE 100 index of leading shares, for example, at one point registered the strongest daily percentage rise for the UK market in 15 years, following its sharpest one-day fall in eight years, and remains almost at a seven-year low. Meanwhile, the Standard & Poor's index of leading US companies fell almost 50% since its peak. Germany's Dax Index fell to a seven-year low and the FTSE Eurotop 300 index to a six-year low. The Nasdaq index had lost 75% of its value since the peak. In Japan, the Nikkei is at a 20-year low.
Despite some recovery in April in all these markets as the war with Iraq proceeded apace to its end, equity markets are still at extremely low levels.The banking system, though, does continue to function. According to The Banker's database, Tier 1 capital ratio, the measure of a bank's strength, for countries in the Organisation for Economic Co-operation and Development (OECD), excluding Japan, is a healthy 13.48% and aggregate Tier 1 capital is $1360bn. However, in a possible vicious circle, banks' capital could come under serious pressure if the bear market were to continue for 10 years, which in turn would lead to further downward pressure on share prices.
Banking challenges – Capital raising. Raising capital in a bear market is both difficult and unappealing, yet a number of banks would need to do so. The Japanese banks are a known worry. What is a newer and potentially bigger concern is the state of the Germans: in a private meeting, Deutsche Bank chief executive Josef Ackerman floated the idea of the state taking over some banks. The average Tier 1 capital ratio for German banks is 6.8%, which is less than half the 13.4% of OECD banks excluding Japan, according to The Banker (see table below). Their average non-performing loans (NPLs) are double that of OECD banks excluding Japan. Even more worrying, only six banks out of a total of 287 declare their NPLs.
One competitor at a non-German bank with a solid balance sheet says the German banks' problem is not the need to sell some of their extensive shareholdings in domestic industry at a time of depressed markets but that they will be forced to sell some of their key businesses.
"There is already an expectation that Commerzbank and Hypo need to come to market to strengthen their capital bases," says the head of the financial institutions group at an American bank.
Even with current expectations of a more benign market scenario, a behemoth like Allianz, the world's largest insurance company by premium income, is under fire. In March, a rumour did the rounds in Frankfurt and London that if the Dax index fell to 2000, the Munich-based insurer would face difficulties. Allianz then announced the largest-ever fully underwritten rights issue. Its decision to raise about E5bn ($5.4bn) of new capital – via a E4.4bn discounted rights issue and a subordinated bond – led to a fall of almost 10% in its shares. Shareholders are reluctant to throw good money after bad when they fear Allianz may need more funds, whether to bolster its capital or to avoid further downgrades from its AA- credit rating.
Even smaller issues may prove difficult. Last year, for example, UK bank HBOS put most of the proceeds of a £1.2bn share placing into Clerical Medical, its insurance business. It is doubtful that sort of issue would go through now. "There is a relative scarcity of capital, and raising capital for marginal businesses will not happen," says Matthew Sebag-Montefiore, a director at banking consultants Oliver, Wyman & Company.
What sort of capital to raise is also an awkward question. As regulators worldwide step up their supervision and increase rules on what constitutes Tier 1 capital, banks that often have the maximum allowable amount of so-called "innovative" types of cheaper capital are being forced to look at other instruments. In the UK, these have been termed "middle bucket" and are subordinated debt instruments with a number of conditions attached. With regulators on high alert, though, it is unclear how many new instruments will be allowed, while risk-averse investors may be wary of the untested.
Mr Sebag-Montefiore suggests that some banks may be forced to separate out their corporate from their retail side. In that way, at least half the bank would be "whiter-than-white" to ensure customer trust, as well as possibly making it easier to raise funds.
Japan provides some indication of the risks of raising bank capital in a long bear market. The five leading banks have sought to raise a total of ¥1700bn ($14bn) in new capital before stricter rules on NPL disclosures make their results look worse. Some are having to accept selling their shares at heavy discounts; others are having to sell strategic shareholdings to foreign banks, like Sumitomo Mitsui Financial Group to Goldman Sachs and United Financial Japan to Merrill Lynch; while yet others are issuing preferred shares. Institutional investors need deep pockets.
- Pension funds. An added problem is that pension fund investments have already been depleted by the past few years of the bear market. Take London-based oil giant BP: its latest accounts show a total pensions deficit of $5.4bn. The funding positions on its US, European and UK plans plummeted by $7.5bn last year. Its return assumptions in all these markets were and still are optimistic. In the US, for example, until the end of 2001, it had been assuming an 11% nominal return on US equities. It has now lowered that to 8.5%, which is rather hopeful in the current circumstances.
A number of pension funds are lowering their equity exposure and increasing the bond component of their portfolios, as are insurance companies; and as institutional investors sell equities, stock markets fall, worsening the problem of expected returns.
"A long-term bear equity market scenario would not only aggravate the problem of under-funded pensions; it would also cause a fundamental re-examination of rules of thumb that, in the past, have caused firms to take excessive exposure to equity markets relative to fixed income instruments," says Mohammed El-Erian, managing director at Pimco, one of the world's largest active bond managers with more than $300bn under management.
However, exposure to low-yielding bonds – even if this represents some diversification of the risk – will not necessarily fill the gap. As a result, corporate and bank balance sheets will suffer. In a vicious circle, this leads to rating agency downgrades, which in turn make it more difficult and more expensive to raise funds in the market to repair the balance sheets. A case in point was the recent downgrade of German steel company Thyssen-Krupp because of pension shortfalls by both of the main rating agencies, Standard & Poor's and Moody's. Investors are still unaware of how serious the issue is. But as the rating agencies and analysts start to pay more attention to pension deficits, investors will start marking down the shares of quoted companies that need to deal with the financial hole.
- Cost cutting. Cost cutting is the other side of the coin for banks and many of them have already been on major slashing campaigns. But it is not a long-term solution.
"Only a handful of banks can achieve double-digit growth when containing costs. You have to increase costs to get more revenues. A better strategy is to spend to innovate to drive fee income," says Mr Sebag-Montefiore.
Walid Boustany, head of group strategic planning at global bank HSBC, agrees. "We were criticised recently because our expenses continued to grow. But this is because we are continually investing in new cost-reduction initiatives, customer-relationship management, sales forces and acquisitions to position ourselves to take advantage of revenue flows," he says. "I don't subscribe to a 10-year bear scenario but if that were the case, weaker institutions might be stretched to invest in this way."
– Asset management. How can banks increase the share of wallet from their customers? Much lower consumer demand puts paid to the retail strategy of most banks, which have been seeking to increase fee income to make up for narrowing interest rate spreads.
"In a sustained bear market – a likely scenario – substitution would come to an end," says Mark Weil, a director at Oliver, Wyman & Company. Assets under management would fall, as would consumer take-up of extra, higher-margin equity products. Japan provides a case in point. So does the US, where already there is a net outflow from mutual funds. And in the Netherlands, there has already been a switch away from market-related savings products to life insurance policies with guaranteed returns.
In that sort of market "your main preoccupation is preserving capital", says Larry Brainard, a senior adviser at German bank WestLB.
Banks that operate in Asia have had some experience of this but for them fee income has been a partial solution because of the developing nature of their markets. Mervyn Davies, group chief executive of Standard Chartered Bank, which receives 80% of its revenues from Asia, says: "We have been operating in deflationary markets and coping with asset price falls of circa 50% for some years. It requires a different management approach. We are used to it in Asia." The bank has focused on markets that are still growing with yield-enhancing products for middle-income earners but it has also cut costs radically.
Another Asian bank has a similar strategy. David Li, chairman and chief executive of Hong Kong-based Bank of East Asia, says that, although the bank's loan business is affected by the weak economy, it recorded an increase in profit last year, albeit before provisions. "We did so because we took steps three years ago to shift our business towards fee-based income. We acquired a respected insurance company and have built what is now Hong Kong's largest provider of corporate services. This includes services such as company secretarial work, share registration and compliance," he told The Banker.
The same strategy would probably not work in the more developed OECD markets, where the penetration of insurance products is already much higher.
- Retail dominance. Despite the lack of revenue from the retail side, a 10-year bear market would result in the dominance of retail banks over corporate ones. Business investment would fall, leading to a continued drop in corporate lending. Mergers would be out. Dividends and cash flow would become more important – arguably they already have.
As banking is highly leveraged to gross domestic product, low growth or even deflation would mean less fee income (as discussed above) but there should still be better growth than in the corporate side of the business.
Nonetheless, with personal levels of indebtedness so high in the US, and with consumer credit in the US a high-margin business, it is not obvious what will replace it as the growth engine for US banks. Corporate and investment banking will not fill the gap.
- Investment banking. Some of the worst effects will come on the investment banking side of the business. In 2003, the US experienced its first January with no initial public offerings since the bear market of 1974, while in 2002 there was the smallest number of stock market debuts since 1991. There is not enough money in bonds and derivatives to make up for this, while second- and third-tier investment banking players may retreat to their home markets.
A firm that is more aware of the high probabilities of an extended bear market is Lazard, which believes it has its finger on the pulse because of its extensive work in the restructuring business. "Lazard is the only pure advice firm left that is truly global. We work with clients around the world every day and see that companies are still actively restructuring their balance sheets. It is clear that a recovery may not be right around the corner," says Ken Jacobs, head of Lazard in the US and deputy chairman of the global firm.
He says the universal banks have not yet adjusted to the scale of headcount reduction that is needed. "No-one has ever had to shrink like this. Most banks have scaled back to 2000 levels but that is not enough if we have markets like 2002 for the next 10 years. Few investment banks have business models that match the low activity of the early 1990s," he says.
In fact bank restructuring, as well as non-bank restructuring, looks as though it will be a major source of business for banks. Some investment banks may even be forced to sell off some of their key businesses to bolster their balance sheets.
Worst case scenario
There is an even worse scenario. A systemic threat could come from Germany, which has worryingly low levels of capital and whose banks could then cause a systemic risk in the world banking system.
The interconnectedness of the international financial system is the worry. Sir Andrew Large, who as deputy governor of the Bank of England is responsible for monitoring financial stability, recently gave a speech warning that, on an international scale, increased links between insurance firms and banks meant systemic risk was no longer confined to banks. "The silos that were securities, lending and insurance are no longer silos," he said.
Insurers are already experiencing the vicious circle of bear markets. As they sell equities into a falling market to bolster their solvency ratios, the markets fall further. Regulators are so worried that they have eased solvency requirements and look set to ease them further.
Derivatives may prove the spark that lights the bush fire. Through derivatives, banks have transferred credit risks – now deteriorating – to insurers. The market for custom-made derivatives is estimated at $120,000bn and has been growing by more than 10% every six months, according to the Bank for International Settlements. In his annual letter to shareholders, legendary investor Warren Buffett warned of "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal".
Better scenarios
Even with a more benign scenario, there are major hazards facing financial institutions. "The big risk for banks is consumer credit in the US and the UK, and corporate loans in Europe – especially Germany," says Peter Oppenheimer, head of portfolio strategy, Europe at investment bank Goldman Sachs in London. "But banks are in better shape than normal because, unusually, most of the bubble was financed by the capital markets, not the banks. This means that, ultimately, the real losers are consumers because of the loss of pension assets. This implies much lower consumer demand in the future and, therefore, slower growth."
David Roche, president of Independent Strategy and one of the more bearish strategists around, is looking for a post-Iraq rally and the market to then fall and reach new lows. On a longer term basis, he predicts either slow adjustment or meltdown.
"The slow adjustment is the central scenario still. But the downside risk would happen if the Iraq aftermath is a mess and if North Korea [developed into a crisis] which is a bigger risk," he says.
Assuming the US consumer deleverages and there is limited GDP growth, then Mr Roche predicts a situation in which "the sector does not recover much and goes ex-growth. Margins get squeezed across the board. Fat investment bankers get thin".
Horst Köhler, managing director of the International Monetary Fund (IMF), insisted in mid-March that financial markets would "bounce back", barring a protracted war in the Middle East, even as he admitted that the IMF's official forecast of global growth had to be substantially downgraded from 3.7% to slightly more than 3%.
It is usual for officials to try to give reassurance, even as markets plummet, but the optimism expressed by market participants appears unwarranted.
Recovery prospects
In a study on markets in the US and Europe from 1750, Mr Oppenheimer notes that many of the characteristics of what he terms a "structural bear market", as opposed to shorter cyclical and event-driven bear markets, are evident in the current one (see graph above). Ultimately, however, he concludes that there are reasons to suggest this downturn will not be as long as an average 10-year structural bear.
"I think this bear market may be shorter than the worst ones in the past, measured from peak to trough, because we do not have a deep recession and because the collapse in profits and write-down of investment have come through more quickly," he told The Banker. Yet he thinks the recovery will take 10 years or more. "The reason for this is that there are fewer drivers for a recovery this time. Bond yields are not likely to fall sharply from here, neither is the equity risk premium, and we do not have a strong rebound in consumer spending to look forward to. I would guess the rebound from this bear market will therefore be slower than normal recoveries."
Mr Oppenheimer's other reasons for relative optimism include the fact that free trade remains largely unaffected, that major structural bear markets are associated with price shocks (be they significant inflation in the 1970s or significant deflation in the 1930s and 1990s in Japan) and that the banking system is still functioning, which sets the current environment apart from the 1930s, Japan in the 1990s and even several countries in the 1970s.
None of those three reasons seems watertight. The expanding conflict between the European Union and the US, along with the missed deadlines in the Doha trade round, could disrupt world trade. The probability of price shocks is high. Oil at $40 a barrel would be a problem, while a worst-case scenario of $80 a barrel due to Middle East disruption and continuing Venezuelan problems shaves 2% off global GDP.
Meanwhile, the US consumer, the bulwark of the global economy in the past couple of years, is no longer on a spending spree, according to the latest data, giving added impetus to the threat of deflation. After all, with the US Federal Reserve funds rate at 1.25%, the Fed and other central banks have little room for manoeuvre.
The future is abysmally difficult to predict but banks are facing some of the most challenging times in two decades, whether a modest recovery takes place or if there is an extended bear market. In the worst case, systemic risk is a possibility; in the best case, many banks are going to have to reassess their strategies to survive as going concerns. Taking an ostrich-like attitude while hoping for better times is not an option.
