US financial industry needs to reinvent itself
One of the highlights of last week's Jamaica Stock Exchange National Investor Education Week was a comprehensive presentation by Albert "Bud" Lowenthal on the state of the US financial industry.
Lowenthal is the Chairman, CEO and majority shareholder of broker dealer Oppenheimer and Company, the leading player in Jamaica's Eurobond trading through the efforts of their Atlanta based bond trader Gregory Fisher. He also has a longstanding connection with Jamaica, having got married here in 1967, the same year he entered the securities industry.
Starting with the impact of the US financial crisis, Lowenthal noted that we learned that "ratings may not matter" and financial models could not be relied upon. Despite quantitative easing (QE) 1, 2, and 3 (as well as the current operation twist), which had quadrupled the balance sheet of the Federal Reserve, confidence in the US financial system had eroded with "financial services in disrepute". Lending and financial returns had also been restricted as capital requirements increased, and there was now a recognition of sovereign risk, "particularly for countries whose debt exceeds their GDP".
Despite the efforts to end the large banks being "too big to fail", part of the Wall Street Reform and Consumer Protection Act "Dodd Frank", the financial system is now even more concentrated. However, the prohibition on proprietary trading and permitted "risky" investments to three per cent of equity capital, part of the so called "Volcker Rule", will severely limit depositary institutions, such as commercial banks, from trading their own capital. This will have large direct and indirect costs, particularly to issuers and consumers, who are likely to see reduced liquidity, higher fees and less service, but will provide new opportunities for non -traditional players, who will now have an opportunity to go into capital market businesses formally dominated by the major banks.
Moving to the state of the international markets, he noted the European sovereign debt overhang was driving the slowdown in Europe, and Asia was also slowing. The US, although growing slowly at a rate of about 1.5 per cent, did not appear to be slowing further yet. However, although the excess liquidity created by the Central Banks had "seeped into the stock market", this did not yet appear to have gone into other less liquid markets such as real estate. Despite the increase in regulation, so far there did not appear to be much more transparency about risk. Ultimately, Lowenthal believes, all the money created will lead to a rise in inflation.
In terms of its impact on Jamaica, there were now two markets for risk, with a reduced demand for higher risk issues and excess demand for "safe" higher rated debt. This meant that it was now difficult to find risk capital for new projects, in areas such as infrastructure, hampering growth. Areas such as tourism were also impacted by the European uncertainty, and weak US consumer demand.
Some of the impact will be temporary, but some will be permanent.
Amongst the temporary risks are the threat to the Euro, and the fact that markets are likely to remain fragmented and uncertain for at least another three years. Higher interest rates, whenever they arrive, will actually signal a return to normality in the markets, including a more normal allocation of risk. The US will continue to overreact to the issues that brought on the financial crisis, with the result that consumers will see higher cost credit and lower availability. Spending will therefore be limited to those with jobs, savings and the ability to re-pay debt.
Amongst the permanent changes are higher capital requirements, the Volcker rule (it will permanently eliminate certain risks from commercial banks), centralisation of derivatives (this will reduce profitability and thus liquidity of the more exotic forms), migration of talent from more regulated to less regulated firms, and the lack of profitability raising the cost of capital.
More specifically, the impact of the Volcker rule and Basle 3 will reduce the willingness of banks to carry an inventory of securities. The move to an agency market (meaning that the firm act as a pure broker "middleman" rather than a market maker "principal") is likely to be permanent, so that the customer will hear "leave your order with me" and "I will get back to you" from his broker. Issuers will also have shorter windows to issue new securities as the current risk on/risk off environment will continue to affect markets and their receptivity to a new issue.
New market players will however, emerge, and gravitate to less travelled markets. Smaller players are likely to have better information and markets as they will be more dedicated with fewer distractions, creating better relationships. Oppenheimer, as an independent (non - bank) Broker- Dealer will not be impacted by the Volcker Rule or Dodd Frank, as it has always been an agency player that depends more on its local knowledge and relationships. In addition to its investments in the Caribbean, it has broad capabilities in money management ($21 billion under management) and capital markets, employing 300 dedicated professionals between equities and fixed income (in addition to its nearly 1,500 financial advisers) and other staff.
Lowenthal finished by noting that "data is in oversupply, but information is not", and that Oppenheimer intends to "be a reliable partner to our clients and play for the long term".