text:
This action might not be possible to undo. Are you sure you want to continue?
Just as some species become extinct in nature, some new financing techniques
may prove to be less successful than others.
Assistant Secretary of the Treasury for Financial Markets Anthony W. Ryan before Congress in September 2007
oliverwyman.THE of Financial Services Evolution Making Sense of the Past.com . Preparing for the Future by Niall Ferguson and Oliver Wyman Oliver Wyman is a leading global management consultancy www.
surges and spasms 4 the role of regulation: Intelligent design? 5 evolutionary lessons in financial services 6 Concluding remarks Bibliography Acknowledgments 9 12 16 28 46 66 75 99 100 105 .COntentS executive Summary Introduction 1 the consensus view of the industry 2 A century of change in global financial services 3 Of cycles.
but an evolutionary one. regulatory structures went through major dislocations. risk management and good governance. sometimes with astonishing speed. we do not discern perennial "golden rules". see many similarities to the process of biological evolution. we question the assumption that there will be inexorable institutional convergence (as best practice spreads) and concentration (because of economies of scale). Indeed. high liquidity and global integration) have been subject to sudden reversal in the past. From 1914 to 1980 there were two world wars. We find that many widely-held views are not safe when considered in the light of several economic cycles. tracing the evolution of financial services over more than a hundred years allows us to set our own times in an unusually broad perspective. A crucial point is that the financial world today is much more like that of the beginning of this period than that of any intervening period. exogenous factors often identified as core engines of finance growth in the early twenty-first century (stable macroeconomic growth. At the same time. The consensus view also takes for granted continued improvements in technology. volatility has already returned to financial markets. suggests that such endogenous sources of growth have not advanced in a linear fashion.exeCutIve SuMMAry The objectives of this report are to test the consensus view of the financial services industry against long-run historical data and to form insights that are based on more than just the last few years. we find a proliferation of forms in the industry and a tendency for institutional diversity to persist. and cannot be relied upon to continue in the future. THE EvoluTion of financial sErvicEs . In contrast. Demand for financial products grew in aggregate but was highly volatile in individual segments. The future will not be simply a continuation of the recent past. In this light. as we have been writing this study. nor can we afford to wait for the infrequent appearance of "black swans". Similarly. The long-run view has led us to the intriguing notion that financial services is neither a deterministic nor a wholly stochastic system. a Great Depression and a Great Inflation – to say nothing of the exclusion of more than half of humanity from the global economic order. it would be highly optimistic to project forward the relative calm of the last decade. multiple revolutions. however. The historical record. however. During this time liquidity waxed and waned. which we believe can explain observed phenomena and – by extension – provide future guidance. frequently in response to unforeseen crises. We do. When making pragmatic decisions. thanks to the spread of Communism. Financial services were provided by a whole host of different supplier forms that came and went at a remarkably rapid pace. factors commonly cited as posing near-term threats to the financial services sector (changing demographics and global imbalances) may have acted as growth drivers for the industry.
As in the natural world. As in the natural world. the environment is characterised by punctuated equilibrium: the macroeconomic environment can change spontaneously or the rules can be changed by regulatory intervention. The boards and executive officers of financial services firms would do well to Keep it natural: growth works best when it is based on real advantage and organic innovation Discard industrial plans: because evolution does not work in neat five-year planning cycles. First. are quite different from the consensus imperatives of "get bigger". customers and other resources is paramount to longevity Worry more about habitats and less about competitors: obsessions with competitors can stunt innovation and miss big waves that lead to habitat loss for all Buy insurance: extreme shocks will almost certainly happen in the future – effective risk assessment should lead beyond conventional insurance to the development of "re-birth" plans These lessons. This contrast is even greater when the implications for regulators. Third. or "stick to your knitting". A new framework also gives us new pointers for the future and offers valuable lessons for those running the industry today. We do not posit evolution as simply an interesting analogy but as a better framework for understanding industry trends. no formula works forever – today's successes will be tomorrow's failures unless they adapt and innovate. continuous out-execution (with bold moves where necessary) beats grand strategic designs Make yourself more attractive: winning the competition for talent. While there are important differences between biological and financial evolution. "Intelligent design" of the underlying rules of the game seems like the logical role for this privileged group of industry leaders.At any given time. capital. "diversify". Importantly. the financial services sector is populated by many different institutional forms competing for resources. emanating from the evolutionary perspective of finance. Second. neither system has a single end-goal – looking for this or planning around its assumed shape are futile. three fundamental similarities stand out. 10 . mutation is part of the system – spontaneous innovation is to be expected and should be encouraged. extinction is an integral part of the system – those kinds of firms that under-perform and fail to adapt ultimately disappear. there is persistent (though not random) mutation. supervisors and policy-makers are considered. however. regulators stand little chance of designing timeless rules for a constantly evolving system. On closer inspection. cycles and events.
Without such a long-term perspective.We regard this report as the first. THE EvoluTion of financial sErvicEs 11 . word in forming a clearer view of the financial services industry – soon to account for 10% of global production. current and future industry leaders will struggle to run a critical sector of the economy that in some way underpins most other sectors. rather than the last.
2 In fact. and casting doubt on what we identify as the consensus view on the future of financial services. in the sense that certain business practices perform the same role as genes in biology.1 We believe this has important implications for both financial firms and regulators. with the outcomes in terms of longevity and proliferation determining which business practices persist A mechanism for natural selection through the market allocation of capital and human resources and the possibility of death in cases of under-performance.g. In this report.e. 85 2 12 . The path-breaking contributions were by Alchian (150) and Nelson and Winter (182). the financial services industry has many of the defining characteristics of a true evolutionary system "Genes". Since 11 there has been an entire journal devoted to the subject. privatisation and securitisation. Quasi-Darwinian language ("only the strong survive") is frequently heard on both Wall Street and Lombard Street. where the neoclassical general equilibrium approach remains dominant See e. though within a much more compressed time frame. Our analysis shows that financial development follows an evolutionary pattern. Thorstein Veblen (188) raised the question and Joseph Schumpeter (143) was sceptical about the applicability of Darwin's ideas to the process of economic exchange. yet the full magnitude of these changes and their implications for the future can be appreciated only if they are put in a longerterm perspective. It may strike some readers as commonplace that the financial services sector resembles an evolutionary eco-system.IntrODuCtIOn Few would dispute that the past ten years have witnessed dramatic changes in the financial services sector around the world: deregulation. pp. The Journal of Evolutionary Economics. Kindelberger (184). i. at a time when the global macroeconomic environment may be in the early stages of a profound change. "differential survival" 1 The notion that Darwinian processes may be at work in the economy is not new. globalisation. The evolutionary model nevertheless remains outside the mainstream of economics. to name but a few. tracing the major developments in world finance over roughly a century. we attempt to take the long view. However. allowing information to be stored in the "organisational memory" and passed on from individual to individual or from firm to firm when a new firm is created The potential for spontaneous "mutation". technological Competition between individuals within a species for resources. usually referred to in the economic world as innovation and primarily. though by no means always. previous discussions of financial evolution have tended to be content with superficial analogies based on rather limited understanding of neo-Darwinian thought. similar in character to that witnessed in the natural world.
an initial slim advantage may translate into a prolonged period of dominance. the result of institutional mutation and natural selection. thereby avoiding the danger that natural selection ultimately produces a world with only one version of "the fittest" Scope for extinction. random "drift" (innovations/mutations that are not promoted by natural selection. Broadly speaking. Financial organisms are in competition with one another for finite resources (customers. with species dying out altogether Financial history is. Financial disruptions (like the Great Depression of the 1930s or the Great Inflation of the 1970s) are like the asteroid strikes and ice ages that periodically intervened in the evolutionary story of life on earth. Scope for speciation. that is. market share). nevertheless. they can cause mass extinctions of financial species. evolved complexity protects neither an organism nor a firm against extinction – the fate of most animal and plant species. evolution is not progressive.3 note that this may not result in the evolution of the perfect organism. and vice versa. any more than the microscopic prokaryotes that still account for the majority of earth's species. Periodic exogenous shocks can radically alter the evolutionary environment. or the emergence of altogether new species. 3 4 Dawkins (18) Gould (18) THE EvoluTion of financial sErvicEs 13 . But market selection is the main driver. when environmental change is more gradual or less profound. Finally. American practices are adopted by Chinese banks) play a part. but just happen) and "flow" (innovations/mutations that are caused when. There can also be "co-evolution". they eliminate the less fit members. rendering certain evolved traits disadvantageous that previously had been advantageous. say. Institutions with a "selfish gene" that is good at self-replication (and self-perpetuation) will tend to endure and proliferate. in milder cases. because of the sensitivity of the evolutionary process to initial conditions. sustaining bio-diversity through the creation of wholly new "species" of financial institutions. certain financial species may become dominant. when different financial species work and adapt together.4 In extreme cases. At certain times and in certain places. this process is not wholly endogenous. without necessarily being optimal. But innovations by competitor species. it is worth bearing in mind that in the natural world. prevent any permanent hierarchy or monoculture from emerging. A "good enough" mutation will achieve dominance if it happens in the right place at the right time. in sum. the law of the "survival of the fittest" applies. clients. as used to be thought (notably by the followers of Herbert Spencer). Primitive financial life-forms are not condemned to oblivion.
In the firm's official "family tree". not perfect. financial innovation begins at a common trunk. 8. mergers and acquisitions can lead directly to mutation. animals eat one another. because a firm can adapt within its own lifetime to change going on around it. whereas in the world of financial services. so as to maximise our genes' success". in which those successful genes provide the message that instructs the development of the next generation. it is just eating. Over the long run. p. admittedly. numerous small firms are seen to converge over time on a common "trunk". In financial organisms. In the evolutionary process. rather than random change. conscious innovation.The analogy is. However. this is precisely the wrong way to think about financial evolution. The conventional view of financial development tends to see the process from the vantage point of the successful survivor firm. most mutation is deliberate. The fact that a particular firm successfully devours smaller firms along the way is more or less irrelevant. Over time. In financial organisms. taking the long view. 5 George C. Firms are not quite the same as biological organisms. including your friends and relatives. in which the closest thing to a golden rule is "don't cheat. Williams. When one organism ingests another in the natural world. the following summary of evolutionary theory by an eminent biologist is at least suggestive that the resemblances outnumber the differences. there is no counterpart to the role of sexual reproduction in the animal world (though demotic sexual language is often used to describe certain kinds of financial transaction). 14 . unless it is likely to provide a net benefit". but that is not the driving force behind evolutionary mutation and the emergence of new species and sub-species. And in the natural world there are no regulators or governments. Indeed. in which that message is always "exploit your environment. financial evolution (like cultural evolution) may be more Lamarckian than Darwinian in character. we can discern some of the most important trends in the evolution of financial services. the trunk branches outwards as new kinds of banks and other financial institutions evolve. and identify possible future developments as both natural selection and intermittent shocks exert their influence on the population and forms of financial institutions. the present-day conglomerate. quoted in Dawkins (2003). The ultimate purpose in life [is] to be better than your neighbour at getting genes into future generations. Still.
More often. These processes are often accelerated in times of economic disruption.The implication is that economies of scale and scope are not always the driving force in financial history. regulators must be careful not to impede them out of a misguided sense that established firms are all "too big to fail". more commonly. get "eaten". the real drivers are the process of "speciation" – whereby entirely new types of firms are created – and the equally recurrent process of "creative destruction" – whereby weaker firms die out or. THE EvoluTion of financial sErvicEs 15 .
We begin by summarising what we see as the prevailing consensus on the state of the financial services industry – the view held by most investors. But these seem too remote. For the past 10 years. the sector is thriving in a benign global economic environment. Wealth creation and economic liberalisation – the two fundamental drivers of financial services growth– have been sustained and are spreading among international economies. despite recent write-downs arising from the sub-prime mortgage defaults and the credit crunch in the market for collateralised debt obligations and other asset-backed securities "Unity in Adversity". or too limited in scale to have a profound impact on the provision and consumption of financial services in the decade ahead. managers and media observers based on trends of the past decade. accounting for 7% of global GDP and rising return on capital is the highest ever: 20% at year end 20066 employment in the sector is at its highest level ever Loss rates are still below cyclical averages. it is no surprise that the financial services sector has attained new peaks 1 tHe COnSenSuS vIeW OF tHe InDuStry total industry value is ~$6 tn. While the cost of regulation relative to the size of the industry is increasing. several potential threats to this benign environment. There are. bubbles in emerging economies. 2007 6 16 . continuing volatility in credit markets. At the same time. under these conditions. global imbalances (notably the uS current account deficit). the fiscal and monetary policy mix has also contributed to a marked reduction in macroeconomic volatility. admittedly. doing a good job of protecting consumers and maintaining financial stability. The Economist. and competition authorities are. up 60% over the last ten years total revenues are ~$2. according to the conventional view. For the most part. the benefits of supervision (such as fewer bank failures) are becoming more tangible. by historical standards.a. climate change. and keeping unemployment levels below 10% in most developed countries. and the threat of terrorism. The principal threat to the sector may come not from excessive regulation but from innovations (for example in the derivatives market) beyond the control of established monetary and regulatory authorities. regulators. analysts. too uncertain. policy makers. the world economy has been growing at an average annual rate of ~4% p. September 6. regulators. such as the ageing of the population.7 tn.
asset managers. and governance. 1. insurers. or public enterprises) have an unprecedented choice of financial products and providers.000 500 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 North America Europe Asia Pacific Latin America Rest of World Source: oliver Wyman.500 3.000 2. marketing. they have better ways of determining which products and services are best for them. which projects revenue growth of 77% in combined global financial services revenues between now and 2017.500 2.000 1. corporations. Customers (be they individuals. others are negative. More important. risk management. but overall the outlook is highly optimistic.Banks. GlobAl fiNANCiAl SerViCeS reVeNUeS for The lAST AND NexT DeCADe 4. not least because of the spread of transparency through the Internet. THE EvoluTion of financial sErvicEs 17 2017 . we have integrated multiple quantitative and qualitative views to create a picture of financial services growth over the past decade. Some are positive.500 1. The future of financial Services (2005) Such an optimistic consensus view seems to be predicated on the continuation of several key trends. The consensus view is that the financial services sector is about to progress from one golden decade to another.500 4. and other providers of financial services have become better at innovation. In figure 1.000 3. production. despite occasional and inevitable business cycle setbacks.
the Chinese economy has increased in size by a factor of ten. Here. In China. the consensus view is of a benign global environment for financial services. and large parts of Asia. 2007 18 .A SUpporTiVe mACroeCoNomiC poliCy CoNTexT An important factor in the recent period of sustained growth and low inflation (see figure 2) is that the world is currently enjoying (in the words of The Economist) an "unusually benign economic climate"7 and relative political stability. With an average rate of real per capita GDP growth of 8. Capital controls have become the exception rather than the rule. with exports still the key driver of growth in Asia. to prevent a repeat of the Asian crisis of 1997-8. Fiscal deficits have not been eliminated. Monetary authorities. the Americas. having largely won the battle against high inflation in the 1980s. the ratio of uS per capita income to China's per capita income is now approximately 23 to 1. the Bush administration's tax cuts and its lavish expenditure at home and abroad. Although progress has slowed in the World trade Organization's Doha round. trade in goods and services has continued to grow. Political unrest and conflict have been minimal in europe. with measurable impacts on service sector labour costs and on manufacturing. Perhaps the most heartening news of all. Only Sub-Saharan Africa. may 17. however. which might otherwise have risen further as a result of the deficits due to the 2001-2 recession.g. parts of the Middle east. 7 "The Alchemists of finance". India. According to calculations by Goldman Sachs. At the same time. russia. and a handful of other failed states (e.4% since 1978. in this mainstream view. there has been no significant upturn in protectionism. a fifth of humanity is on the march. is the recent and projected growth of the biggest emerging economies – Brazil. This implies an extraordinarily rapid convergence. the ratio could be less than 3 to 1. too. and China – as well as the many smaller countries benefiting from economic openness. there have been significant improvements at the national level in both fiscal and monetary policy. The Economist. restrictions on immigration have not prevented unprecedented integration of the global labour market. Haiti) are still crippled by internal instability. Their huge accumulations of dollars and dollar-denominated bonds have tended to depress long-term interest rates in the united States. Asian central banks have adopted more or less pegged exchange rates and accumulated very large foreign exchange reserves. but they have generally been kept below the 5% of GDP threshold. By 2050. have adopted a variety of different approaches with the common objectives of price stability (a consumer price inflation rate of below 3%) and sustainable growth (a growth rate that does not exceed or undershoot productive capacity). and financed in a noninflationary way (through bond sales).
and wine) which. Some worry that excessive liquidity could fuel either consumer price inflation or bubbles in one or more asset classes. iNflATioN rATeS AND iNTereST rATeS % 30 25 20 15 10 5 0 -5 1981 1991 1999 2001 -10 1970 1972 1974 1976 1978 2003 1983 1985 1987 1989 1993 1995 1997 2005 GDP growth Inflation rate Interest rate Source: mitchell (2003). effiCieNCy AND GlobAl iNTeGrATioN Though the recent crunch has reduced the availability of credit in many markets. enjoyed a long and largely uninterrupted bull run from 2003 until the summer of 2007. art. Increased efficiency in the capital markets. and globally integrated as never before. For precisely this reason. has lowered transaction costs and made the movement of capital freer than at any point in history. capital markets are also widely believed to be more efficient now than at any point in history. But most market participants plainly prefer excessive liquidity to a credit crunch. Frictional costs involved with transferring capital from one financial instrument to another are at an all-time low. In addition to being more liquid than ever. aided by improvements in technology and greater competition between exchanges. liquidity is still high. The recent efforts of some central banks to try to avert a credit crunch have only increased liquidity. along with traditional assets.2. distressed debt. GlobAl GDp GroWTh. regulatory barriers to capital movement and ownership have been removed to the extent that. oeCD. supported by foreign governments and investors. cross-border ownership of assets of most traditional kinds has become very common. within the developed world. some countries (mainly in the english-speaking and Mediterranean worlds) have been able to maintain large current account deficits. Financial institutions from developed economies are reinforcing this trend by seeking new revenue opportunities in THE EvoluTion of financial sErvicEs 1 . The availability of capital has allowed – even forced – investors to diversify their holdings into increasingly exotic asset classes (such as special situations. oliver Wyman analysis hiGh liqUiDiTy. Capital flows freely across borders and limits to foreign ownership are being relaxed throughout the developed (if not the developing) world.
and the deficits of the world's defined-benefit pension funds will be exposed. low-growth markets) while developing economies invest in highly rated securities originating in more mature financial markets. retirementrelated assets are expected to reach $25 tn by 2010. All this may create opportunities for those financial institutions that are able to adapt quickly to the new social order. european. 8 Deloitte (2007) 20 . As the post-war "baby boom" generation of the developed world begins to retire. The proportion of the uS.8 Investment demand will shift from stocks to bonds. Most analysts expect this trend to have major financial consequences. nevertheless. particularly in developed nations. the popularity of annuities will rise. The DemoGrAphiC CoNTexT Although the global macroeconomic environment seems generally favourable. Wealthy retirees are likely to require new products and services. and are likely to be more financially sophisticated than in the past. dependency rates are set to rise.developing countries (setting up subsidiaries or engaging in joint ventures outside their own mature. Governments will likely have to bail out under-funded pension systems. most commentators expect these demographic changes to have a negative impact on financial services as a whole. conventional wisdom holds that demographic changes are likely to create financial problems. and Japanese population aged 65 and over is expected to increase from 20% today to more than 36% by 2050 (see figure 3). while the working-age population will see their tax burdens rise to pay for the growing number of dependents.
Although this state of affairs is sometimes referred to as a "stable disequilibrium. while the country's foreign exchange reserves stand at well over $1 tn – larger than estimations of even the biggest sovereign wealth funds (see figure 4). Dunaway. eUropeAN. It is important to recall that about 20-25% of China's GDP depends directly on trade with the uS.3. AND JApANeSe popUlATioN 2000-2050 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 <14 Source: United Nations 15-64 >65 GlobAl imbAlANCeS The conventional wisdom also has it that the biggest short-run threat to financial stability arises from global imbalances: the current account deficits of the uS. eSTimATeD AGe DiSTribUTioN of US. Similarly. The current account surplus of China is now around $200 Bn." it is not hard to see how it could become unstable. (2005) THE EvoluTion of financial sErvicEs 21 2050 . other "Anglosphere" and Mediterranean countries. A major realignment of the Chinese currency (estimated to be undervalued by as much as 50%)9 would sharply increase the cost of imported manufactures to the developed world. which accounts for a fifth of Chinese exports. the surpluses of Asian emerging markets and energy-exporting countries. and their mirror image. any downturn in the uS economy would have repercussions around the world. and li.
0 $BN 200 150 100 0. Improving the volume and speed of communication drives competitive advantage in an industry in which information transfer is crucial. ChiNeSe bAlANCe of pAymeNTS AND foreiGN exChANGe reSerVeS $TN 1. generating enormous income and wealth in the process. non-financial institutions are also increasingly offering 22 2006 0. How are financial institutions likely to evolve under these circumstances? The consensus view foresees a continuation of the following trends. retailers are venturing into consumer finance and retail banking. while some utilities are starting to trade financial instruments. Financial institutions' spending on and use of information technology is likely to continue to increase as companies seek to achieve greater productivity. Industrial companies are holding increasing volumes of interest rate and foreign exchange derivatives. then. the global macroeconomic environment is exceptionally benign from the point of view of financial services. Partly because of technological innovation. mostly to mitigate the various risks of doing business. simple products have become increasingly commoditised. the financial services sector is tending to overlap more and more with other industries such as energy. with firms ever more focused on selling high volumes at low margin. Liquidity remains abundant. CoNTiNUeD rApiD iNNoVATioN AND iNVeSTmeNT iN TeChNoloGy In recent years. At the same time.5 50 -0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Foreign exchange reserves Source: SAfe China Current accound balance Summing up the conventional wisdom. and healthcare. hedge funds and investment banks have found ever more inventive ways to generate returns and structure financial instruments.0 -50 . But the overall outlook is rosy. true. real estate.4. despite the credit crunch of August-September 2007. demographic trends and global imbalances are worrisome.
5. new techniques and instruments have allowed banks to lower their risk profiles significantly. as new niche markets emerge.financial services. Firms are seeking to remove risk from the balance sheet altogether through the sale of repackaged assets such as mortgage-backed securities (MBS) and asset-backed securities (ABS). uK retailer tesco is now in insurance. While regulatory demands are a burden to financial institutions. volkswagen has become one of Germany's fastest growing financial institutions by financing private used car sales. As figure 5 shows. whose primary purpose is to trade these instruments. and community banking are all notable areas of growth. outstanding CDSs have grown from next to nothing 10 years ago to more than $20 tn today. For example. Islamic banking. takaful insurance. improVemeNTS iN riSK mANAGemeNT The consensus view is that aided by regulation and innovative financial products. socially responsible investing. new entities like conduits and Structured Investment vehicles (SIvs) have emerged. some are likely to cluster around their natural geographical hubs – the Middle east or South-east Asia for Islamic banking and insurance. but not to reverse it. financial institutions have raised their risk management techniques to a level of sophistication and effectiveness never seen before. At the same time. there is some evidence of speciation within the financial services sector. and WalMart has entered retail banking in Mexico. firms are now using derivatives and other tools to diversify balance sheet risk through the purchase of credit default swaps (CDS). GroWTh of GlobAl CDS mArKeT $TN 25 20 15 10 5 0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Source: bbA THE EvoluTion of financial sErvicEs 2006 23 . As these niches grow. for example. recent turbulence in the credit markets and attendant doubts regarding the accuracy of credit ratings are likely to slow progress in this direction.
federal reserve bank of New york ABS traditional securities exchanges are declining in significance and are expected to decline in number. and over-the-counter (OtC) sales of complex financial instruments are increasingly common. as traditional balance sheet banking declines in significance. replacing the bricks and mortar exchanges of the past. Combined issuance of ABS and MBS has grown from nothing in the mid 1980s to over $3 tn annually. The exchange of tomorrow is likely to be an entirely virtual entity. packaging and removing risk from the balance sheet is increasingly being seen as the most important skill in banking. originating loans and holding them on the balance sheet is no longer considered the way to run a successful bank. While gathering assets in the form of deposits is still important. 24 2006 .Financial innovation is happening at a remarkable pace.000 1. electronic exchanges are taking their place. Indeed. In response to these pressures. seeking strength through greater volumes of business and by forging complementary partnerships both regionally and globally.000 2. 6.500 1.500 2. exchanges are consolidating. GroWTh of GlobAl AbS AND mbS iSSUANCe $BN 3.000 500 0 1980 1982 1984 1988 1990 1992 1994 1996 1998 2000 2002 1986 2004 MBS Source: Thomson financial. The booming markets for secondary securities such as corporate mortgage backed securities (CMBS) and retail mortgage backed securities (rMBS – see figure 6) are testament to this decline.
Compliance failure brings its own new risks. This long-term trend towards concentration seemed to follow the logic of economies of scale and scope. MiFID. Solvency II. This new. it was widely believed that the long-term trend in financial services was for consolidation and the emergence of an ever-smaller number of ever-larger firms – a tendency symbolised by the creation of Citigroup. insurance companies. the London Stock exchange.g. both directly and indirectly.. as experienced by other mature industrial sectors of the economy in the twentieth century.GoVerNANCe AND iNSTiTUTioNAl formS until recently. accountability. Basel II. accounting. and operational risk. and other large multibusiness. Germany. multi-geography providers. such as the uS. SUperViSioN AND reGUlATioN Another threat identified by most commentators is cumbersome regulation. A recent change in sentiment seems to be driven by scepticism about cross-border ownership structures and the risks hidden in highly complex. and Italy) but emphasises industrial logic as well as sheer size. so additional regulations paradoxically can make the world a more risky place for financial services companies. Another recent development is the increased degree of activism within the financial services shareholder base. The recent experiences of Deutsche Börse. more nuanced view sees further industry-wide consolidation (especially in countries where finance is fragmented. and corporate governance. The rise of private equity partnerships. and IFrS are likely to increase costs for financial services companies by forcing them to enlarge their legal. THE EvoluTion of of financial sErvicEs THE EvoluTion financial sErvicEs 25 . diverse organisations. partnership. SarbanesOxley. security. and compliance divisions. The consensus view is that publicly quoted financial corporations will increasingly be influenced. since nearly all the new regimes push for higher standards of transparency. by activist investors. HSBC. and other "professional" investors (e. and other entities identified as targets by private equity acquirers are testament to the rising activism of the sophisticated shareholder. regulations are likely to become even more burdensome in the areas of privacy. hedge funds. even if their net effect is to increase systemic stability. pension and mutual fund managers) has created a much more knowledgeable and active shareholder base.
we have identified a number of themes which define the conventional wisdom on the financial services sector. based on experiences of the past decade At the international and national level. though again on balance positive High rates of innovation and improvements in technology will continue Sophisticated risk management and transfer techniques will continue to marginalise traditional banks and exchanges Shareholder activism will also increase. which could lead to potential instability if. China's currency were to appreciate sharply The outlook for the sector is also somewhat ambivalent.oVerVieW In this chapter. imposing changes in the governance and ownership structures of financial services organisations Supervision and regulation will continue to impose costs as well as systemic benefits 26 . counter-cyclical stabilisation. which may create shifting and unpredictable demands for financial products Global imbalances will persist. fiscal and monetary policy offer a benign combination of liberalisation. for example. as will high levels of global integration and capital market efficiency Demographic trends will move a large proportion of the population into retirement. trade. and low inflation that is not about to disappear very high levels of liquidity will continue.
THE EvoluTion of financial sErvicEs 27 . regulation. though capital markets are moving the sector into the unknown increasing complexity of operations and systems one of the largest customer segments (especially for technology) It seems to us that the answers to most of the challenges now facing financial services are broadly couched in terms of product design and distribution. It is widely assumed that "best practice" is being rolled out globally in all areas of the industry. this is how the conventional wisdom looks: Consumer Employee Investor increased complexity of offering proliferating product ranges increasing technological sophistication Size of employer as a company growing increasing specialisation and complexity of roles within organisations increasing outsourcing abroad high degree of cyclicality in fS stocks as investments increasing m&A activity increasing private equity activity and activism Manager Regulator Service provider pay more frequently performance-linked Competition as fierce now as ever regulations increasingly burdensome industry moving more and more towards risk-based frameworks Stability and diversification are the most important trends.From the perspective of different industry stakeholders. management and incentive structures.
we see that 2 A Century OF CHAnGe In GLOBAL FInAnCIAL ServICeS economic stability and global integration have varied enormously Liquidity has fluctuated widely Global integration has been reversed more than once Financial systems have been faced with high dependency ratios before now Global imbalances are less of a novelty – and perhaps less of a hazard – than a short-term perspective might lead us to assume eCoNomiC GroWTh AND iNflATioN Though the past decade has seen economic stability.6% from 1945 to 1989. Thinking in terms of evolutionary patterns.5% from 1914 to 1945. the norm in recent history has been instability. nominal GDP growth from 1870 to 1914 averaged 2. with significant variations in the growth rate. and 8.9% (see figure 7). however. and unemployment. forces us to take a longer view. Since 1990. 5.1%.6% from 1945 to 1989. Only since 1990 has inflation settled to an average rate of 1. GDP growth has averaged 4. The average rate of inflation was 0.3% from 1914 to 1945.The consensus view is largely based on extrapolation of trends from the past decade. 8. 28 .5%. inflation.6% from 1870 to 1914. and 6. The twentieth century has seen extreme economic instability. If we expand our horizons to consider the past century.
liesner (18). From 1914 to 1945. at 2. UK National Statistics. Spain. Since 1994. volatility was very high at 6. mACroeCoNomiC iNSTAbiliTy iN The TWeNTieTh CeNTUry 70% 60% 50% 40% 30% 20% 10% 0 -10% -20% -30% 1870 1878 1886 1894 1902 1910 1918 1926 1934 1942 1950 1958 1966 19741982 1990 1998 2006 Nominal GDP Growth Inflation rate Source: mitchell (2003). UK. Countries included are US. United Nations. THE EvoluTion of of financial sErvicEs THE EvoluTion financial sErvicEs 2 .7.4 respectively. italy. Germany. and neither measure passed below 1880-1914 levels until 1956.7. the standard deviations of GDP growth and the inflation rate were 3.8 and 7. volatility has been much lower than historic rates.7 and 3. US Census bureau.0 and 1. france and Switzerland From 1880 to 1914. Japan.2 on average (see figures 8 and 9).
8. GDp VolATiliTy iN The TWeNTieTh CeNTUry
40% 35% 30% 25% 20% 15% 10% 5% 1908 1915 1922 1929 1936 1943 1950 1957 1964 1971 1978 1985 1992 1999
France US Finland
UK Switzerland
Germany Austria Norway
Japan Belgium
Spain Denmark
Source: mitchell (2003), oeCD, US bureau of economic Analysis, Carter, Gartner, haines, olmstead, Sutch and Wright (2006), oliver Wyman analysis. Calculated by taking a rolling standard deviation of the past five years of GDp growth. french and German time series have time series gaps during war time
. iNflATioN VolATiliTy iN The TWeNTieTh CeNTUry
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 1880 1886 1892 1898 1904 1910 1916 1922 1928 1934 1940 1946 1952 1958 1964 1970 1976 1982 1988 2000 2006 0%
France Switzerland Finland
UK US Netherlands
Japan Austria
Germany Belgium
Spain Denmark Portugal
Source: mitchell (2003), oeCD, oliver Wyman analysis. Calculated by taking a rolling standard deviation of the past five years of inflation rates
It is also worth noting the extent of regional variation in long-term economic performance. It is widely assumed today that Asian emerging markets will continue to narrow the gap between themselves and the developed economies. One hundred and thirty years ago, a similar forecast might have been made with respect to Japan (see figure 10). In 1874, Britain's per capita GDP was approximately 4.4 times higher than Japan's. By 1940, the ratio was down to 2.2:1. yet the disruptive effects of the Second World War set Japan back almost to square one. It was not until the 1960s that convergence returned to its long-run trend-line. There is an important lesson here for those who make projections in the form of smooth lines.
THE EvoluTion of financial sErvicEs
10. briTiSh/JApANeSe (1874-18) AND US/ChiNeSe per CApiTA GDp (2000-2050)
British/Japanese GDP per capita
5 4 3 2 1 0
US/China GDP per capita
45 40 35 30 25 20 15 10 5 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 0
Source: maddison, A, (2003)
liqUiDiTy AND GlobAl iNTeGrATioN As we have seen, liquidity is generally agreed to be at a very high level today. But what exactly do we mean by liquidity? Liquidity has been defined in different ways at different times, and a lack of liquidity during a crisis rarely means the same thing twice. We consider liquidity to consist of three measures
Cash, deposits, and money market instruments – measured by "Marshallian K": the money supply as measured by the monetary aggregates M1, M2, and M3, divided by nominal GDP
a level equalled at the end of the Second World War. Marshallian K was 0.61 in 1960. it is relatively easy to use Marshallian K. has only been tracked over the past 50 years. liquidity is evidently significantly higher than it used to be. we find that liquidity is still not exceptionally high by historical standards in terms of a narrow monetary measure. rising to 1. however. Measured on this basis.49 in 1914.28). The wartime and Great Depression periods appeared to experience extremely high liquidity. even when we exclude these periods.07 today. M3. but this was primarily due to decreased GDP during these periods. do confirm the high liquidity hypothesis. Calculated using M2. By calculating Marshallian K for all of those markets where data are available. THE EvoluTion of financial sErvicEs 33 . Marshallian K today (0. this being the main measure by which liquidity fell during the summer of 2007 trading activity in markets for financial assets – in terms of volumes traded and bid-ask spreads Over a century.33) is only just above the 1914 level (0. Broader monetary measures. the measure that includes the largest quantity of financial instruments. M3 Marshallian K starts at 0. real and nominal interest rates – where a lower interest rate implies cheaper money and hence higher liquidity. and currently stands at 0. the measure produces some counterintuitive results.66 (see figure 11). we are able to show that liquidity is not currently exceptionally high compared to the last hundred years. Measured using M1. to be sure.
34 .3 0.9 0.1 M1 M2 M3 Source: bank of england.8 0.11.2 1975 1980 1985 1990 1995 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 2000 2005 0.1 1. mArShAlliAN K (liqUiDiTy) iN DeVelopeD CoUNTrieS M1.4 0. Gartner. olmstead. however.5 0. hide numerous crises that have arisen over the past century and a half. Datastream. mitchell (2003).7 0.6 0. oliver Wyman analysis The relatively smooth curves of "Marshallian K".0 0. As shown in Box 1. Swiss National bank. Carter. such crises. sometimes triggered by small events. Sutch and Wright (2006). haines. M2 and M3 divided by nominal GDP (weighted global average) 1. have the capacity to rapidly suck out liquidity from the system.
causing silver price to drop Sequence of events Regulatory reaction Loss of confidence in president Grant and Congress leaders of banking and manufacturing Panic of 1873 The New york Stock exchange closes for 10 days 18.000 businesses fail between 1873 and 1875. paying out $8 mm over 3 hours Trust Company of America's reputation similarly damaged by association and barely survives a run. Trigger banking firm Jay Cooke & Co.A. 8 of the country's 364 railroads eventually go bankrupt Unemployment reaches 14% by 1876 prices of other commodities drop financial trusts collapse and Wall Street comes close to crashing as industrial stocks are hardest hit and railroads go broke european banks sell their American securities resulting in bank run and the closure of 500 banks and 15.000 companies heinze's butte Savings bank fails reports associate the Knickerbocker Trust Company with heinze which closes after suffering a run. heinze tries to corner the stock of United Copper Company which then collapses. Stock market narrowly avoids a crash finances also hit by european investors reluctant to buy the city's bonds 1873-1876 Treasury injects $26 mm into economy Sherman purchase Act was repealed Treasury no longer forced to buy silver with notes redeemable for silver or gold Panic of 1893 president Cleveland and the Democratic party 183-186 Panic of 1907 14-30 october Speculator f.A. losing $50 mm Treasury deposits $25 mm in New york City Trust Jp morgan pressures trust company presidents and bankers into putting up funds to support ailing trusts Associates and associated institutions of f. files for bankruptcy after overinvesting in railroads run on gold supply means that people can no longer exchange silver notes. CrASheS AND pANiCS The following is a brief summary of the triggers and responses to crises in the uS financial markets over the last 150 years. heinze THE EvoluTion of of financial sErvicEs THE EvoluTion financial sErvicEs 35 .box 1 – A brief hiSTory of CriSeS.
10. causing unemployment energy shortages cause the closure of schools and more factories embargo is extended to portugal. portfolio insurers sell in futures market. index arbitragers not active. but stagflation results embargo lifted march 174 National energy security US house of representatives files legislation to eliminate tax benefits for m&As Black Monday 1987 1-20 october US trade deficit for August is above expectations fed lowers interest rates and injects liquidity fed helps banks extend credit to securities firms. liberalises lending of securities and steps up supervisory efforts Circuit breakers introduced Use of computers in stock markets to engage in arbitrage and portfolio insurance strategies 36 . and NySe shares lose $7 bN in 6 weeks Sudden inflation and economic recession hit industrialised countries such as france and US. but prevents arbitrage traders from using DoT system to trade. S&p 500 futures fall 2%. and South Africa Wednesday 14: Trade deficit report pushes dollar down. rumours of exchange closure spark more sales. high volume overwhelms system and trades are reported late Tuesday 20: fed announces it will support financial system. DJiA and S&p 500 drop 23%. rhodesia. unable to mitigate pressure in the futures market fed cuts the interest rate from 6% to 4% Tax raised from 25% to 63% Congress passes the emergency banking bill.Trigger black Thursday (stock market crash) Sequence of events Regulatory reaction Loss of confidence in banks. Depression ends worldwide as countries prepare for World War ii opeC announces a 25% cut in output and threatens a further 5% price per barrel quadruples. the Glass-Steagall Act of 133. Tax announcement and rise in interest rates put further pressure on equity prices monday 1: futures open on time with heavy selling. and other legislation Great Depression 12-13 1973 oil crisis october 173-march 174 opeC announces embargo on petroleum exports to countries supporting israel in its conflict with Syria and egypt president Nixon signs the emergency petroleum Allocation Act Western nations' central banks cut interest rates to encourage growth. lifting market sentiment. gasoline prices double.000 banks fail Third bank panic occurs in march 133 and a bank holiday is declared to avert a run on banks roosevelt announces plans to redistribute wealth from rich to poor 13. and regulators exchange falls 12% on Tuesday Smoot-hawley trade bill is passed in June 130 GNp falls by 31% while unemployment rises to 24% industrial stocks down 80%. governments. pushing down prices.
stocks and bonds soar after the imf announces a $23bN emergency loan package for russia. falling from 5050 on march 10 to 4580 on march 15 2001. hong Kong raises rates to 300% to protect the hK Dollar. Chinese. Dell etc) are processed simultaneously. often without making a net profit Substantial imf bailouts given to affected Asian nations conditional on a series of reforms Central banks across the world intervene to defend their currencies enhanced surveillance by imf and increased focus on prevention of crises introduction of international codes and standards to improve reporting and transparency Asian crisis 1997 17-1 Dot com bubble burst 2001-2003 NASDAq peaks at 5.Trigger may 14: Thailand spends billions of dollars of its foreign reserves to defend the baht against speculative attacks Sequence of events Regulatory reaction Loss of confidence in The imf The governing parties in Asia and russia Thai baht hit by speculation. and governments and central banks resort to imf aid packages.62 on march 10 improvements in the Chinese Wall concept arising from conflicts of interest equity analysts. triggering chain reaction of selling. majority of the dot-coms cease trading after using up their venture capital. Currency crisis spreads through Southeast Asia. ibm. Currencies come under pressure. brazil sees half of its market value erased. while mexico is forced to defend its currency multi-billion dollar sell orders for major high tech stocks (Cisco. fed cuts interest rates 3 times in 7 weeks before Dow rallies.5bN bail-out to lTCm. for publishing allegedly dishonest analysis on firms THE EvoluTion of of financial sErvicEs THE EvoluTion financial sErvicEs 37 .048. fearing collapse could worsen panic. but collapses when russia officially defaults on debts Dow loses 300 points in thirdbiggest loss and falls a further 512 points following turmoil in russia. Consortium of US financial institutions provides a $3. Japanese. Stocks fall in europe latin American stock and bond markets plunge on fears of default and devaluation in South America and global crisis. bubble's deflation running full speed. and Korean currencies come under pressure russian markets affected: Central bank triples interest rates to protect ruble. NASDAq loses % in 3 days.
markets remain jittery as further reports emerge concerning significantly reduced thirdquarter profits and bail-outs of financial institutions The european Central bank (eCb) is forced to inject $5 bN euros into the euro banking market to allay fears about a credit crunch. and also debt bundles involving sub-prime mortgages Defaulting sub-prime mortgages collapse CDos. france. fed and Japan's central bank resort to similar means The bank of england resists but eventually falls into line The fed cuts fund rates by half a percentage point investment banks pump money into funds to shore up value Credit crunch 2007- 38 . and Germany. who are criticised for not spotting companies with credit problems. hedge funds report massive losses: Two funds run by bear Stearns lose all of their $20 bN value. while the fed and the bank of Japan take similar steps eCb loans $130 bN to assuage the credit crunch. london. house prices collapse and short-term credit markets Worries about the sub-prime crisis and fears about how many financial firms are exposed to these problems hit global stocks in US.Trigger Defaults on sub-prime mortgages following drop in house prices Sequence of events Regulatory reaction Loss of confidence in Credit rating agencies.
There are, however, other ways of measuring liquidity. Put in the simplest terms, liquidity means the abundance of money. When money is abundant, we would expect that the price of money (the interest rate) would be low. As figure 12 shows, if we take interest rates as a proxy for liquidity over the last hundred years, we find that the levels of liquidity we are witnessing today are by no means extreme. Average real and nominal interest rates were 4.3% and 4.6% prior to 1914, diverging to -1.0% and 5.1% between 1914 and 1989. Since 1989, the averages have been 3.6% and 4.9%.
12. reAl AND NomiNAl iNTereST rATeS iN DeVelopeD CoUNTrieS
15% 10% 5% 0% -5% -10% -15% 30% 20% 10% 0% -10% -20% -30%
Nominal (left hand side)
Real (right hand side)
Source: bank of england, United Nations, Nber, Global financial Data. Data is for Japan, UK, france, Germany and italy, plus Switzerland, the US and Spain and from 107, 114 and 153 respectively
In view of the different definitions of liquidity, we would ideally combine them all into a composite measure of liquidity: a weighted combination of all the liquidity-related factors tracked for this study (including bid-ask spreads and market capitalisations for the years when data are available). This measure (see figure 13) shows liquidity rising during the late nineteenth century, falling and then rising again during the Great Depression and the Second World War – a time when monetary expansion associated with reflationary policies and war finance outpaced growth. Our proprietary liquidity index tended to decline from the end of the Second World War until the period of financial liberalisation in the 1980s and 1990s.10 up until 2000, liquidity was similar to that on the eve of the First World War. Only in the last few years has it risen above that level.
10 The oliver Wyman liquidity variable consists of a weighted combination of real and nominal interest rates, marshallian K on m1 and m2 and the market capitalisation of world stock and bond markets. Source: mitchell (2000), oeCD Statistics Dept, UN Statistics Dept, Datastream, World federation of exchanges
THE EvoluTion of of financial sErvicEs THE EvoluTion financial sErvicEs
13. oliVer WymAN liqUiDiTy VAriAble for SeleCT eCoNomieS
Global liquidity 100 90 80 70 60 50 40 30 20 10 1921 1900 1907 1914 1928 1935 1942 1949 1956 1963 1970 1977 1984 1991 1998 2005 0
Source: mitchell (2003), oeCD Statistics Dept, United Nations, Datastream, World federation of exchanges, oliver Wyman analysis
Similarly, we would do well not to exaggerate the novelty of contemporary levels of globalisation. The last age of globalization (from the 1870s to 1914) was similar to our own in at least five ways. First, it was characterized by relatively free trade, limited restrictions on migration and hardly any regulation of capital flows. Second, inflation was low and growth relatively stable. Third, there was a wave of technological innovation that revolutionized the communications and energy sectors; among other things, the world discovered the joys of cables, wirelesses, the internal combustion engine and tarmac. Fourth, the American economy was the biggest in the world and the development of its massive internal market became the principal source of business innovation. Fifth, China was opening up, raising all kinds of expectations in the West. russia was growing rapidly too. But after 1914 world markets were disrupted and disconnected, first by economic warfare, then by post-war protectionism. Prices went haywire – indeed, a number of major economies suffered both hyperinflation and steep deflation in the space of a decade. Although technological and managerial innovation did not stop, the American economy ceased to be the most dynamic in the world; it faltered during the war, overheated in the 1920s and languished throughout the 1930s in the doldrums of depression. China succumbed to civil war and foreign invasion, defaulting on its debts and disappointing Sino-optimists in the West. russia suffered revolution, civil war, tyranny and foreign invasion. Both these giants responded to the mid-century crisis by donning the constricting armour of state socialism. In this they were not alone.
Periods of hyperinflation, now unheard of in the developed world hit several european economies during the early twentieth century. Germany suffered two complete currency collapses within less than thirty years. By the end of the 1940s nearly every government in the world, including those that retained political freedoms, imposed restrictions on trade, migration and investment as a matter of course. Some achieved autarky, the ideal of a de-globalized world. Consciously or unconsciously, all were applying in peacetime the economic restrictions that had first been imposed between 1914 and 1918. Only slowly after 1945 were these distortions removed. trade was liberalized well ahead of capital movements; under the Bretton Woods system, most countries retained capital and exchange controls. Banking systems were tightly regulated, where they were not directly state-owned. It was not until after the Great Inflation of the 1970s that the environment became more benign for financial services, beginning with the breakdown of fixed exchange rates and the deregulation of the British and American financial systems in the 1980s and 1990s. It is true that there have been great advances in trade liberalization since the 1940s. As a proportion of GDP, however, trade has not reached unprecedented heights. In the developed world, trade was equal to roughly 20% of GDP from 1880 to 1914, reaching a low of ~10% in the middle of the 20th century, and not rising above 20% again until 1999 (figure 14). World trade declined so steeply in relation to global output during the war-torn middle of the last century that the period after 1945 was mainly about regaining the previous height of global integration. In terms of the relative importance of trade, in other words, we are living through Globalisation 2.0. The clear lesson of history is that the process of globalisation can be reversed, no matter how far it has advanced.
THE EvoluTion of of financial sErvicEs THE EvoluTion financial sErvicEs
Germany. Denmark and Netherlands 1132006. and hence the degree of capital mobility between them (assuming that there is no credit or transfer risk associated with the securities). belgium 11-2006. an arbitrage opportunity is created.1% (see figure 15). Norway and Sweden 115-2006. One way of illustrating this point is by measuring the differences in sovereign bond yields across markets both in terms of absolute differences and taking into account changes in the exchange rate between two markets. thereby eliminating the gap. imporTS AND exporTS from SeleCTeD DeVelopeD eCoNomieS AS A proporTioN of GDp Trade as % of GDP 30 20 10 0 -10 -20 -30 1879 1888 1897 1906 1915 1924 1933 1942 1951 1960 1969 1978 1987 1996 1870 2005 -40 Imports Exports Source: mitchell (2003). Austria 12-2006. 11 This figure excludes the 122 UK-Germany figure which was 7% 42 .1%11 from 1914 to 1945. The average size of this arbitrage gap between the uS and the uK and between Germany and the uK was just 0. Where a gap exists between the expected return on. Assuming perfect capital mobility. for instance. Japan 1885-2006. portugal 150-2006. Spain 100-2006.14.0% from 1945 to 1985. United Nations. oliver Wyman analysis. UK and italy 1870-2006. rising to 1. only recently exceeding the levels seen in the early 1900s. Countries included: france. we are able to determine the difference in expected yield in a unit of currency invested at the same time in two different countries. before falling again to 0. and 1. traders should quickly take advantage of this opportunity.28% between 1870 and 1914. a dollar invested in new york compared with a dollar invested in London at the same time over the same period. Cross-border capital market integration lost significant ground during the mid twentieth century. using spot rates and three-month forward rates between two markets as well as the yield on three-month treasury bills. oeCD Statistics Dept. US 160-2006 and finland 171-2006 International financial markets have evinced a similar pattern. Switzerland 12-2006.
The global environment cannot be counted on to remain as benign as it has been over the past decade.0% 1870 1877 1884 1891 1898 1905 1912 1919 1926 1933 1940 1947 1954 1961 1968 1975 1982 1989 US to UK SD Source: obstfeld and Taylor (2002) Germany to UK SD In short.5% 3. the dependency ratio has fallen from 38% in 1890 to 33% (see figure 16).5% 2. however. there is nothing so very remarkable about the current and projected increase in dependency ratios. it would be a mistake to regard the past ten years as exceptional in terms of liquidity or global integration. From the perspective of a century of history. today around 16% of the developed world's population is over 65. Overall. We have been here before – in the first age of globalisation before 1914 – and history makes it clear that both liquidity and globalisation are capable of ebbing even more rapidly than they flow. DemoGrAphiC TreNDS The demographics of the developed world have certainly changed quite dramatically over the past century as a result of improved life expectancy and reduced fertility. 1996 THE EvoluTion of financial sErvicEs 43 .5% 1. mainly because healthcare for the old and decrepit is more expensive than education for the young and fit. in fact.0% 1.0% 0.0% 3. The problem is that retirees cost up to two-thirds more than children to care for.0% 2. when the majority of dependents were children. ArbiTrAGe GAp oN Three moNTh SoVereiGN DebT beTWeeN US AND UK. GermANy AND UK 4.15. What has changed is the composition of the dependent population. compared with just 5% in 1890.
5% of GDP. Germany. In modern parlance. not least because mental deterioration often precedes physical deterioration. france and Switzerland. between two-fifths and a half of all foreign-owned assets.under the welfare systems set up in the middle of the twentieth century. Countries included are US. including the uS (which didn't begin to export capital on a significant scale until the early twentieth century). A hundred years ago. and 1913." as uK investors sought higher returns in overseas securities than they could achieve at home. Japan. UK. By 1914. public and private pension schemes are already coming under strain for this reason. All over the developed world. liesner (18). British savings (and the returns on past overseas investments) were channelled abroad on a huge scale. But simply raising retirement ages cannot be regarded as a panacea. Between 1870 and 1913 Britain ran a current account surplus that averaged around 4. GlobAl imbAlANCeS There is nothing new about large current account deficits and surpluses either. there was a "sterling carry trade. with a substantial portion going to the country's imperial possessions. 16. This was part of a large-scale flow of resources from Western europe to the rest of the world. men and women often leave the labour force before they have ceased to be fit for work. United Nations. UK National Statistics. Spain. and only partially reformed in the 1980s. expanded in the 1960s. DemoGrAphiC ChANGe of SeleCTeD DeVelopeD CoUNTrieS 100% 80% 60% 34% 40% 20% 0% 32% 40% 38% 1890 1896 1902 1908 1914 1920 1926 1932 1938 1944 1950 1956 1962 1968 1974 1980 1986 1992 1998 Age 0 – 14 Age 15 – 64 Age 65+ Dependency ratio (right hand scale) Source: mitchell (2003). rising above 7% at cyclical peaks in 1872. 44 2004 30% . the uK ran very large current account surpluses.8 Bn. the gross nominal value of Britain's stock of capital invested abroad was £3. 1890. US Census bureau. It is far from clear that employers want to retain workers in their late sixties and seventies. italy.
By our standards.From an accounting standpoint. British surpluses had to be matched by deficits in recipient countries. to contemporaries. oVerVieW The defining feature of the twentieth century is the extent to which the world economy stagnated at the mid-point. the British colonies of white settlement. however. The key point is that the trend of macroeconomic change is neither linear nor evenly cyclical. the uS was the biggest net capital importer. Subsequently. Projecting forward relatively recent trends must therefore be regarded with great caution need a better framework to make sense of very recent events. if not an age of equipoise. regaining the peaks scaled prior to the First World War only in its later years. there clearly was some kind of "global imbalance" that allowed Britain to play such a dominant role in international capital flows. as well as Argentina and Brazil. until the end of the nineteenth century. History suggests that financial developments are characterised by punctuated equilibria. emerged as major destinations for British capital. then. THE EvoluTion of financial sErvicEs 45 . this seemed like a stable disequilibrium.
3 OF CyCLeS. with only minimal reverses. As figure 17 shows. It is easy to forget how recently the new york Stock exchange floor was carpeted with pieces of paper at the end of the trading day. SurGeS AnD SPASMS A longer-term view of the history of financial services underlines the danger of projecting forward the trends of the past ten years. the bulk of communications between financial institutions and their clients were handwritten on paper. the introduction of the desktop computer and basic spreadsheet was less revolutionary than is often assumed. until the 1990s. improvements in productivity in financial services were minimal in the uS before the 1950s. In this context. did cables or telegrams replace letters. the process of technological "mutation" led to significant improvements in commercial banking productivity only quite recently. Financial services organisations have undergone a number of major evolutionary changes – most obviously in the nature of banks – and there have been many mutations in ownership and governance. with a sharper acceleration in the past twenty years. But these innovations were spread over a longer period than is generally realised. but were then sustained. The loNG rUN of iNNoVATioN There is nothing new about technologically driven improvements in the efficiency of financial services. A hundred and fifty years ago. new types of financial institutions have proliferated. The possibility cannot be discounted that we may now be on the threshold of another plateau. In each case. Only gradually. 46 . dealing with all types of customer need. The introduction of the telephone to banking was also a gradual process. It is true that AtMs reduced significantly the number of bank branch staff required and made employees into generalists. The first AtM was introduced in 1967 – forty years ago – and the first desktop spreadsheet application in 1979. Financial innovation has come in surges rather than as a steady stream. The difference probably reflects the greater economies of scale possible in the uS in the period after the Second World War. revenue per employee hour rose from CHF 30 in 1938 to CHF 220 today. as was the adoption of the ticker tape as a means of rapidly disseminating changes in stock market prices. as the telegraph network spread around the world. revenue per employee hour has risen from $42 in 1934 to close to $200 today. most of the benefits of computerization having already been achieved. In Switzerland.
banking assets as a percentage of GDP hit a peak of 113% in 1914 which was not regained (apart from during the extraordinarily low GDP levels of the Great Depression) until the 1960s. Swiss National bank. employee hours are calculated as 8 hours per day for 230 days per year The STrUCTUre of fiNANCiAl SerViCeS oVer The lAST 150 yeArS The ebb and flow of liquidity and of global integration have been the crucial environmental factors in the history of financial services. and not meaningfully overtaken until the late 1980s (figure 18). In developed countries. CommerCiAl bANKiNG proDUCTiViTy iN The US AND SWiTzerlAND US Number of insured commercial banks 16.17. each stage of which was closely correlated to a change in the macroeconomic environment.000 6. The twentieth century witnessed a dramatic rise.000 4.000 2.000 1934 1938 1942 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2002 0 Revenue per employee hour ($) 220 200 180 160 140 120 100 80 60 40 20 0 Switzerland Number of insured commercial banks 250 200 150 100 50 1934 1938 1942 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 0 Revenue per employee hour (CHF) 250 200 150 100 50 2006 0 Number of commercial banks Productivity (total income/man hour) Productivity (interest income/man hour) Source: fDiC.000 14.000 12. The World Wars and the Great Depression held back the financial services sector to such an extent that only in the last twenty years has it been breaking new THE EvoluTion of financial sErvicEs 47 .000 10.000 8. fall and revival of the industry. oliver Wyman analysis.
Sheppard (171). As figure 19 shows. banking assets as a percentage of GDP stand at 154% compared with 77% for deposits. oeCD. today.7 in 1914. oliver Wyman analysis Note: Assets includes commercial. bbA. Deposits have risen considerably more slowly than assets. Swiss National bank. CUNA. The Shinkin banks research Centre. The ratio of assets to deposits today is 2. However. Deposits as a proportion of GDP stood at 66% in 1914. 48 2005 0% . Goldsmith (183). banco de espana. Statistics bureau and Statistical research and Training institute of Japan. This difference partly reflects the relatively low penetration of insurance during the nineteenth century. The bundesbank. pohl (182). bANKiNG ASSeTS AS A perCeNTAGe of GDp 200% World War I 1929 crash World War II 150% 100% 50% 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Assets Deposits Source: mitchell (2003). Deposits include commercial and savings bank deposits only A rather different picture emerges in the case of insurance. fraser. it is also due to the increasing tendency for individuals to hold their wealth not in bank deposits but in cash-value insurance and insurer-provided annuities of various kinds.ground in terms of its relative economic importance. as individuals today choose to place more of their wealth in mutual funds and other savings vehicles rather than in traditional bank accounts. as well as in new investment vehicles such as mutual funds. oTS. up from just 1% in 1880 and 5% as recently as the early 1980s. savings and cooperative / mutual bank assets. a level that was not exceeded in the second half of the twentieth century until 1987. fDiC. 18. which has seen a more sustained long-run expansion in terms of assets and premiums. in 2000 premiums approached 10% of GDP. compared to 1.
1. The thickness of each bar is intended to be roughly illustrative of the relative size and importance of that particular species in terms of the number of firms. ranging from the huge disruptions of the Great Depression and World Wars to the smaller crises of more recent times Over the course of the past century. and on occasion become extinct as a result of these interacting forces Figures 20 and 21 track the evolution of retail and commercial banking. oeCD. investment banking and fund management and insurance – the three main "phyla" within the financial services sector. their assets and revenues. we can see at work the forces of Competition and natural selection of those organizations with traits best suited to the slowly changing macroeconomic environment exogenous shocks in the form of financial crises. Great britain board of Trade. insurance Statistics yearbook. mitchell (188). iNSUrANCe premiUmS AS A perCeNTAGe of GDp World War I 12% 10% 8% 6% 4% 2% 1880 1884 1888 1892 1896 1900 1904 1908 1912 1916 1920 1924 1928 1932 1936 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 THE EvoluTion of financial sErvicEs 1929 crash World War II 0% Source: Sheppard (171). 4 . oliver Wyman analysis If we think of the structural development of the financial services industry in the developed world as an evolutionary process. Annual Abstract of Statistics. shrunk. the populations of different species within the industry have grown.
commercial banking organisations. insurance. This particular branch of retail banking evolved as a push by retail banks to leverage their branch networks in the distribution of non-traditional retail banking products – namely. with high levels of consolidation (especially following the Savings and Loans crisis of the 1980s and similar events in other markets). and bancassurance franchises became absorbed by universal. figure 20 makes it clear that considerable "bio-diversity" remains. The cooperative banking sector has seen the most change. But the only species that is now close to extinction in the developed world is the state-owned bank. or full service. It is often assumed that the most important trend in retail and commercial banking has been towards consolidation.20. The eVolUTioN of reTAil AND CommerCiAl bANKiNG 1900 Internet/direct banks Telephone/direct banks Shareholder-owned private banks High-end private and merchant banks Commercial banks Full service retail and commercial banks Bancassurance Monoline consumer finance and mortgage Subsidiaries of major conglomerates Shareholder owned savings and loans Not for profit savings and loans Government owned deposit takers 1925 1950 1975 2000 2007 An example of the movements in the competitive landscape described in figure 20 is the emergence and retreat of bancassurance. Government ownership of banking organisations – very prevalent in some countries from the 1940s until the early 1980s – has declined steeply as a result of privatisation (but see below for a new manifestation of state ownership in the realm of investment management). However. 50 . The merging of banks and insurers was largely a response to looser financial services regulation. though the model later turned out to be less successful than many had hoped. in this case. and most institutions moving to shareholder ownership. north America and to a lesser extent some european markets still have highly fragmented retail banking sectors.
when it was acquired by Bank of America. For example. Many new monoline financial services firms have emerged in the commercial banking space. survived as an independent company from the time it was spun off in 1991 until 2005. and even traditional non-direct banks are trying to reduce customer "footfall" in branches by offering more and more services online. have remained independent. established in 1982 as a subsidiary of Maryland national Bank. such as Capital One. especially in consumer finance. The eVolUTioN of iNVeSTmeNT bANKiNG AND iNVeSTmeNT mANAGemeNT 1900 Boutique/specialist investment banks 1925 1950 1975 2000 2007 Universal bank division Shareholder owned investment banks Private owned merchant banks Boutique investment managers Alternative investment managers Private equity houses Marketplace/ exchange THE EvoluTion of financial sErvicEs 51 .In other respects. Branch networks have been bypassed for simple deposit-taking organisations. A number of new "boutiques" now exist to cater to the private banking market. Other companies. the story is one of speciation – the proliferation of new types of financial institution – which is what we would expect in a truly evolutionary system. though many of these experienced difficulties during the credit crunch of August-September 2007. MBnA. Direct banking (telephone and Internet) is another relatively recent and growing phenomenon throughout the developed world. 21.
particularly following the 1999 repeal of the American Glass-Steagall Act. with an increasing number of small boutique shops competing alongside the global bulge bracket firms. stock-brokers. There has been a trend towards consolidation. private equity or even both have been a relatively recent phenomenon. universal banks in the German tradition have gained in importance in this sector as regulations have eased. in the sense that publicly quoted investment banks have absorbed a substantial number of privately owned merchant banks.Alternative investment houses specialising in hedge funds. The resurgence of specialist investment banking organisations has also been a recent trend. Modern investment management has evolved in a similar way in the course of the twentieth century. though both have existed in some form for many decades. passed in 1933 to separate retail and investment banking. 52 . and other entities since "Big Bang" in London (see Box 2).
45 2.703 1. bank of england THE EvoluTion of financial sErvicEs 53 . including the removal of the distinction between stockjobbers (market makers) and stockbrokers.170 *Thomson financial. the world.210 66. today. as all the city's stockjobbers were acquired by either banks or stockbrokers. the market makers all sit within banks. Since the Big Bang. ifSl.7% 46. The stockjobbers were run as cliquey old boys clubs with little exposure to international competition. The resulting fallout was the rapid demise of an entire species of firm. and on some measures. London's presence on the world financial stage has changed dramatically.% 360 2005 2. most of which are not of uK origin. SToCKJobberS – Where Are They NoW? Name Akroyd & Smithers Wedd Durlacher mordaunt pinchin Denny Smith brothers bisgood bishop Charlesworth What happened? bought by SG Warburg (subsequently acquired by UbS) purchased by barclays bought and eventually closed by morgan Grenfell (now part of Db) became Smith New Court before being purchased by merrill lynch bought by County Natwest (subsequently bought by SSb) part of Kleinwort benson loNDoN reborN AS AN iNTerNATioNAl fiNANCiAl CeNTre Measure* Domestic equities annual turnover lSe (£bN) foreign equities listed on lSe foreign exchange daily turnover ($bN) UK private equity assets (% of european total) UK private equity fundraising ($mm) 1986 161 0 50 33. london Stock exchange.box 2 – loNDoN'S biG bANG The "Big Bang" in London in 1986 was complex legislation deregulating the financial markets. The City is now the dominant financial centre in europe.
Countries included are the US. financial evolution is not primarily a story of concentration but of speciation: with new forms of services and institutions emerging to take advantage of subtle changes in the economic environment. Torgerson (154). Duet (186). NUmber of fiNANCiAl iNSTiTUTioNS iN SeleCTeD DeVelopeD CoUNTrieS 80. the aggregate value of the industry has been rising.000 50.000 60. the numbers had risen to about 200 banks with around 800 branches. In 1965. The expansion of American banks has been an important factor in this story. italy. Subsequently. Switzerland. Japan.000 20. there has been a prolonged period of banking consolidation across all economies. just thirteen uS banks had a total of about 200 foreign branches. pohl (182). Sheppard (171).000 10. Spain. a wave of failures in the uS and europe during the Great Depression reduced the total number of banks by a third in a little over a decade. UK. the pursuit of economies of scale. however. as figure 22 makes clear. Schiffer (162). driven by regulatory changes. bundesbank. By 1987. yet. The trend of demutualisation has also reduced the number of mutual and cooperative banks by more than half in just twenty years. mura (16). As early as 1970 the deposits of uS banks with branches in Britain exceeded those of the uK clearing banks. from just $1 Bn in 1890 in the markets of the developed world to roughly $5 tn today (figure 22).000 70. Davies (2002). 22.000 40. and improvements in systems and technology.000 1900 1904 1908 1912 1916 1920 1924 1928 1932 1936 1940 1944 1948 1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 0 Commercial Banks Mutual funds Saving Banks Mutual & Cooperative Banks Hedge funds Source: oeCD. oliver Wyman analysis.The total number of banks in developed countries peaked at the beginning of the 1920s (see figure 22). 54 . bátiz-lazo (2004). france and Germany As the number of banking organisations has been falling.000 30. Since the mid 1980s.
13 Because they do not come under the aegis of the Investment Company Act of 1940. and ravenscraft (1). respectively. mcenally.3 tn). the number had increased more than twenty-fold and assets under management by a factor of nearly thirty. ranging from convertible arbitrage to short selling. and insurance companies ($18. "Alternative investment industry performance and Trends" (2007) 14 Ackermann. Although the first hedge fund was established as long ago as 1949 (by the Columbia university sociologist Alfred Winslow Jones).000 1. The estimated gross investments of the five largest hedge funds amount to around $100 Bn. pension funds ($21. For the sector as whole the figure is $6 tn. 10-14 2002 1 0 THE EvoluTion of financial sErvicEs 55 .15 12 Securities exchange Commission (1).74 tn of assets under management.23. oeCD. 15 mcKinsey Global institute (2007). They now account for between a third and a half of all in trading in the uS and uK equity and bond markets. mutual funds ($19.000 100 100 10 10 1 1911 1890 1897 1904 1918 1925 1932 1939 1946 1953 1960 1967 1974 1981 1988 1995 Industry value Source: frASer. oliver Wyman analysis Average firm value even as giants have formed in the realm of investment banking.14 The ability of hedge funds to leverage their positions greatly magnifies their share of global financial market activity. pp. hedge funds are able to pursue multiple investment strategies. the SeC counted a mere 400 hedge funds with just $50 Bn of assets under management. At the time of writing.6 tn). 13 hedge fund research.5 tn).12 By the end of 2006. Datastream. new and nimbler species of investment vehicles – such as hedge funds and private equity partnerships – have evolved and proliferated. In 1992. eSTimATeD VAlUe of The fiNANCiAl SerViCeS SeCTor iN DeVelopeD eCoNomieS Industry value ($BN) 10. there were at least seventeen distinct hedge fund strategies. their emergence as major players in global financial markets is a relatively recent phenomenon.767 funds with $1.000 Average firm value ($MM) 1. As of the second quarter of 2007 there were 9. somewhat less than a tenth of the assets under management by.
private equity. The Great Depression of the 1930s and the Great Inflation of the 1970s stand out as times of major discontinuity. highly leveraged positions unravelled fast. then has undergone a profound transformation. with natural selection determining which new traits become widely disseminated. such as Bain Capital and Monitor Clipper. this process has been accelerated or disrupted by major financial or regulatory shocks. an attrition rate of just under 37%. there has been significant innovation within these new species. have established partnerships with strategy consultancies.16 Banking. Could something similar happen in our time? The most famous hedge fund crisis to date affected just one firm (Long term Capital Management) in 1998. 16 ibid. By 2012. with several funds (i. taking the total for assets to $710 Bn at the end of 2006. Of the total number of funds. Others.e. the figure could be as high as $15. however.2 tn.7 tn. Most recently.There has been a somewhat smaller surge in the number of private equity partnerships and the assets they manage. There was a lesser-known crisis in the 1960s when poorly hedged. One estimate for the total assets under management by hedge funds. Sovereign wealth funds are also playing an increasingly important role in the realm of investment. there were just 143 hedge funds in existence.17 The sharp change in credit conditions in the summer of 2007 created acute problems for certain hedge fund strategies (quantitative and long/short especially). the rapidly accruing hard currency reserves of manufactured goods exporters and energy exporters are producing a new generation of sovereign wealth funds. Between 1989 and 1996 1. Both trends seem certain to reduce the number of these entities within the next quarter.308 new funds were formed. In January 1989. 12 17 managed Accounts reports 56 .. sovereign wealth funds and central banks is $8. with "mass extinctions" such as the bank panics during the Depression and the Savings and Loans crises in the 70s. even as the state has retreated from banking in most markets. p. though there is clearly no danger of outright extinction. Sometimes. Fortress) running multiple business lines. usually innovation ("mutation") has been an evolved response to the environment and competition. leaving them vulnerable to redemptions by investors and/or absorption by investment banks. 533 ceased to exist by the end of 1996. reducing the number of funds from 200 to less than a quarter of that number. Another important feature of the recent credit crunch has been the pressure on investment banks to bring other kinds of relatively novel organisms (conduits and SIvs) back on to their balance sheets.
Both are easier for small firms. the very difficulties that arise as publicly owned firms become larger and more complex – the diseconomies of scale associated with bureaucracy. remerging with insurance companies as ventures proved less successful than expected. both of which track the emergence and retreat of bancassurance. As market share has been picked up THE EvoluTion of financial sErvicEs 57 . in many cases. All that matters is that you are good at surviving and reproducing your genes. As in the natural world. The financial equivalent is being good at generating returns on equity and generating imitators employing a similar business model. the long-run trend is very different from that predicted a century ago by socialist critics of "finance capitalism" like rudolf Hilferding. the emergence of hungry giants does not preclude the evolution and continued existence of smaller species. in finance as in nature. Mutual insurers are a species that can be seen in figure 24 to be waning. Indeed.even so. though evolution may have led you to become both big and complicated. the pressures associated with quarterly reporting – make it very probable that new kinds of private firm will flourish. who assumed an inexorable movement towards more concentration of ownership. Firms were picked up from the insurance industry by banking organisations before. 24. What matters in evolution is not your size nor your complexity. Size isn't everything. The eVolUTioN of iNSUrANCe 1900 Mutual life insurer 1925 1950 1975 2000 2007 For profit life insurer Integrated insurer Bancassurance Non-life insurer Mutual health insurer For profit health insurer Reinsurance Marketplace/exchange A parallel can be drawn between figure 24 and figure 20.
with the emergence of a small number of giant global players. merged with or been acquired by for profit insurers. the global reach of the world's largest insurers has increased in the last few decades.by for profit enterprises. the more important trend is towards diversity. yet the emergence of for-profit health insurers provides further evidence of the importance of speciation in the long run. however. true. Here too. The modern history of insurance also tends to be thought of as a story of concentration and consolidation. 58 58 . the need for mutual insurers has diminished and many have either become. a trend dating back to the beginning of the twentieth century when companies such as Prudential (uK) began expanding overseas.
box 3 – loNG-Term AND CyCliCAl GroWTh While the banking sector has enjoyed strong real growth rates for the past ten years. much of this is unusual in relation to longer-term twentieth century trends. The more recent 1946-1979 period. Growth from 1995 to 2000. examining the long-term growth trend of financial services value and its relationship to underlying GDP in the countries in which it operates. the business cycle has also played a role in the changes in value of the industry. The 1914-1945 period was characterised by war. with financial services currently growing at ~4% above trend. reAl AND expeCTeD GroWTh iN The VAlUe of The bANKiNG SeCTor 1873-2003 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 1873-1913 1914-1945 Actual 1946-1979 Expected 1980-2003 Within each time frame examined. exhibited real growth of 5%. and depression. relative to the growth of GDP over the same period. leading to low real growth. Similar periods can be identified throughout the last 150 years. THE EvoluTion of financial sErvicEs 5 . The period 1980-2003 stands out in terms of the divergence of real and expected growth rates. only just above the long-term average. ran well above trend at 15% annually in real terms. The chart below indicates whether the change in financial services value relative to GDP growth over the same period has been running above or below expectations based on trend lines. for instance. inflation. though not nearly so detached from the drivers as today. characterised by high inflation and unstable markets. The period 18731913 exhibited above-average real growth. we can determine whether for any period of time the change in value has been running above or below trend.
there was a surge of public ownership. private ownership has been 18 Nicholas lardy. The banking system was nationalised in India in 1969. 21 and 24 highlight several distinct trends in the ownership of financial services. State-run banks have tended to lag behind their private sector counterparts. non-performing loans at Chinese state banks equalled 18% of the total. institute for international economics 60 2007 0 . Developing countries still have far greater proportions of state-owned banks. The most recent trend (see figure 25) has been towards privatisation (technically the sale of state-owned equity to the public). however. Allowing banks to become joint-stock companies enables them to acquire much larger capital bases.18 25.oWNerShip Figures 20. For other small financial services companies. The biggest French banks suffered a similar fate in 1981. Covers all countries in europe even as state-owned banks have declined in importance. with China and India the two most obvious examples. many privately owned banks have moved towards public ownership through stock market listings or sales to already listed institutions. Some smaller firms such as boutique investment banks and niche private banks have remained as partnerships or otherwise privately (sometimes family) owned. In 2000. most obviously in Central and eastern europe. such as hedge funds and private equity firms. In the middle of the twentieth century. NUmber of fiNANCiAl SerViCeS priVATiSATioNS ANNUAlly iN eUrope Number of privatisations 25 20 15 10 5 1991 1985 1986 1987 1988 1989 1990 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: privatisation barometer. nationalised banking sectors were rare. though there remain some state-owned banks in Western europe (such as the German Landesbanken and individual institutions like Sweden's soon to be privatised SBAB). for example. early in the twentieth century. by contrast. There are notable exceptions to this trend.
Are hedge funds and private equity partnerships the mammals in our evolutionary analogy. THE EvoluTion of financial sErvicEs 61 . it represents a return to the days of purer capitalism. The emergence of private equity and other activist investors is not a new phenomenon. At the moment. after all. At some points in time. most can be shown to exhibit broadly similar trends in the emergence of financial services organisations. and the evolution of alternative investment firms have occurred in many different countries at different times. and hence the price of each oscillates. with only a handful of the bigger players recently electing to list on stock markets and sell equity stakes to the public. talented individuals can get much higher compensation by taking slightly more risk and setting up their own businesses outside established firms. the demutualisation of life insurance and savings firms. even if the causal relationship remains a subject for debate. such as the private banking boom of the early twentieth century and the private equity boom of the eighties.19 Personal wealth. The growth of investment companies. One of the forces driving the creation of "private capital" providers is producer compensation. the financial services sector appears to be in the midst of a kind of "Cambrian explosion". The GeoGrAphy of fiNANCiAl eVolUTioN Despite the differences among economies in terms of regulatory environments and cultures.the norm for decades. waiting to inherit the earth when the dinosaurs fall victim to severe change in the financial environment? Perhaps. the penetration of investment banking. Financial intermediation does seem to correlate quite closely to economic growth. the main driver of change in financial services. if we look back a century. Where. with existing species flourishing and new species (like hedge funds and private equity partnerships) increasing in number. would the hedge funds be without their prime brokers? In evolutionary terms. then. it should be noted. however. the importance of each of these ebbs and flows with the market environment.g. If we accept that different countries will tend to evolve along similar but not identical paths – which seems an obvious lesson of financial history – then it is possible to see a pattern in the evolution of financial services. Over time. the relationship between small and large entities is more symbiotic than competitive – a case of "co-evolution" in action. A wealthy middle class is 1 See e. and infrastructure/technology. Whether this will be a cyclical blip or a fundamental shift in corporate ownership and governance will not be clear for some time. The whole of financial services can be thought of as having three factors of production: human talent. financial capital. is growing rapidly in the world's developing economies. Indeed. Sylla and rousseau (2003).
deposit accounts and mobile phone payment systems. The size and wealth of the middle and upper classes. fDiC. the poor are beginning to use products like microfinance loans.000 GDP per capita ($) Source: United Nations. those who use financial services more and with greater sophistication.emerging that demands an increasing range of choice and level of sophistication in financial services products. while GDP per capita gives a proxy for the wealth of the population (see figure 26). An examination of the current penetration of financial services within the world's economies gives us a rough proxy for financial services' sophistication and development. Large portions of the population in such economies still do not have a bank account and use only the most basic financial services 62 .000 US France Germany Hungary South Korea 100. are harder to quantify. oliver Wyman analysis If we group economies according to their level of financial services penetration. Figures for deposits per capita show us the relative penetration of financial services. people's bank of China. we can broadly identify three groups of markets Nascent markets are those with very low penetration of financial services.000 Emerging Advanced South Africa Norway Japan UK Canada Czech Republic Spain Italy China Bulgaria Russia 10. fiNANCiAl ASSeTS AS A perCeNTAGe of ToTAl WeAlTh AND GDp per CApiTA Financial assets as a % of wealth Nascent 80% 70% 60% 50% 40% 30% 20% 10% 0% 100 India 1. At the same time. 26. oeCD.
are european banks going to be vulnerable to a harsher macroeconomic environment in the wake of the credit crunch? 20 South China Morning Post. new hubs like Dubai are also emerging in the states surrounding the Persian Gulf. Long-established centres such as Hong Kong and Singapore are growing rapidly as the markets around them expand. Emerging markets are those with a strong retail and business banking sector. of the asset base of developed economy banks. In europe. in terms of both sector and geography.000 corporate customers in the first half of 2007.7m online clients". high insurance penetration and fast-growing demand for investment products. and investment banking products Advanced economies are those with a mature financial services industry experiencing fast growth in only the most sophisticated and innovative areas – pioneering investment banking products (derivatives. structured products etc. In other words.) and complex investment vehicles and asset classes. 17 July 2007 THE EvoluTion of financial sErvicEs 63 . compared to ~25% towards the beginning of the twentieth century (see figure 27). Islamic financing including sukuks. capital is now equivalent to less than 10% of assets. capitalising on regional wealth and demand for emerging product sets such as Islamic finance (including takaful insurance. The aggregate effect of these changes is to reshape the financial geography of the world. increases of ~50% year over year. it is striking to note that capital adequacy of banks in the developed world has been on a slow decline. "iCbC draws 30. insurance-wrapped savings. At the same time. including private equity and hedge funds One example of the tremendous growth currently being witnessed in developing markets is the Industrial and Commercial Bank of China. with demand fuelling massive growth in any fund sold through a Chinese retail bank. and Islamic retail and corporate banking). As emerging markets grow. new financial services hubs are emerging to complement and compete against the existing financial centres in the developed world. investment products. which added more than seven million internet banking customers and 200. Much of this is attributed to the increasing diversification. having evolved in such a way as to minimise the ratio of capital to assets. The question remains how far banks in the developed world have the resources to withstand a period of reduced liquidity (in some segments of the financial system) and of increased competition from emerging markets.20 Investment funds are simultaneously becoming very popular in China.
or even a combination of the three. American banks have exported their modes of operation to other financial centres. This survey of a century of trends in financial services highlights its similarity with an evolutionary eco-system – neither develops smoothly and both are susceptible to long-dated cycles as well as sudden proliferation surges and extinction spasms. Borders were closed and capital flows stemmed by exchange controls or rendered impossible by war. the defining characteristic was disruption. often in very large numbers. CApiTAl AS A perCeNTAGe of ASSeTS iN eUropeAN bANKS 25% 20% 15% 10% 5% Source: benink and benshon (2002) oVerVieW The last century. but it has also allowed new species to form and to proliferate. has been characterised by relatively benign climates at the beginning and end. for example. and a period of prolonged interruption which started in 1914 and did not die down until the 1980s. Though the drivers and effects changed over time.27. This collapse of the international economy reduced the demand for financial services disproportionately compared to other sectors. natural selection has tended over the long run to reduce the number and increase the size of certain species of financial institutions. Stock exchanges were closed for periods of time which today are almost unimaginable – the new york Stock exchange closed for almost six months at the beginning of the First World War. financial crises and 64 1900 1903 1906 1909 1912 1915 1918 1921 1924 1927 1930 1933 1936 1939 1942 1945 1948 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 0% . in summary. though the dominant trend is for genetic mutation rather than homogenization. from war to recession to simply a lack of growth or integration. There has been considerable "gene flow" between populations as. The evolutionary process has been subject to recurrent exogenous disruptions in the form of geopolitical shocks. the only multi-day closure during the past twenty years having been in the wake of 9/11. The impact on financial services firms was severe.
there seem to be few rules that can be relied upon for very long – few "north stars" that can be used by the various stakeholders to steer by. which is widely understood by scientists to operate without a divine guiding hand. The evolutionary process is indeed a complex one.regulatory interventions (or lapses). At first sight. regulators and policy-makers have the power to change the rules of the financial system at a stroke of a pen. This complexity makes the role of regulators and policy-makers exceedingly difficult. THE EvoluTion of financial sErvicEs 65 . These shocks have led to significant changes to the financial population as whole. not least because of the ebbs and flows of liquidity and global integration. the quite frequent but unpredictable incidence of financial crises and the erratic interventions of legislators. and even the outright extinction of entire species. This is perhaps the biggest difference between financial evolution and natural evolution.
new rules and regulations can make previously "good" traits suddenly disadvantageous. with a good insight into the way that the private sector works. where change is essentially random in character (hence Dawkins's image of the blind watchmaker). Large numbers of under-capitalised banks were a recipe for financial instability. The introduction of deposit insurance in 1933 did much to reduce the vulnerability of banks to runs. Sudden changes to the regulatory environment are rather different from sudden changes in the macroeconomic environment. At the same time. Capital requirements for banking organisations were low for much of uS history. The rise and fall of Savings and Loans was also due in large measure to changes in the regulatory environment. the existence of a large number of banks in the early twentieth century was an anomaly created by peculiarities of uS regulation. The difference is that there is an element of endogeneity in regulatory changes. Designed to take deposits and supply long-term mortgages to local clients. financial services firms evolve according to the peculiarities of their own environments. which affected banks that had 4 tHe rOLe OF reGuLAtIOn: InteLLIGent DeSIGn? 66 . But what makes these environments distinctive is not just a matter of economic performance or culture. evolution in financial services occurs within a regulatory framework where – to borrow a phrase from anti-Darwinian creationists – "intelligent design" plays a part. The combined effect of these rules was a surge in the number of banks during the late nineteenth and early twentieth centuries.Whereas evolution in biology takes place in the natural environment.000 in a single year during the Depression. when Maine became the first state to legalise interstate banking. It also has to do with the role of regulation. there were obstacles to setting up banks across state lines. the net effect is the same as climate change in biological evolution. which resemble environmental changes in the natural world. Bank runs were a regular occurrence and caused the demise of many financial institutions – 4. since those responsible are often "poachers turned gamekeepers". the banking sector remained highly fragmented until after 1976. The 1864 national Bank Act significantly reduced the barriers to setting up a privately owned bank. S&Ls came under acute pressure during the inflationary 1970s. However. Darwin's species of finches adapted by random trial and error to the islands on which they lived. However. Partial deregulation in the 1980s encouraged some S&L managers to adopt reckless and sometimes fraudulent practices. The STAbiliSiNG effeCT of reGUlATioN In many ways. In the same way. A comparable episode in europe was the Secondary Banking Crisis in the uK between 1973 and 1975.
A chronic shortage of rural credit then forced a partial u-turn as the government encouraged the growth of cooperatives and rural branches. 28. changing the environment in which evolution takes place and the rules under which it operates.262 to 42.been lending money for the purchase of consumer durables.000 0 0 Number of bank failures Source: fDiC Deposit insurance limit The primary focus of most regulators is to maintain stability within the financial services sector.000 100.000 180. for example.500 2. for example. a "lifeboat" operation prevented thirty of these firms from collapsing.000 60. Bail-outs of failing institutions by regulators through direct capital injections. in which retail customers lose current and savings deposits. bANKiNG fAilUreS AND DepoSiT iNSUrANCe iN The US Bank failures 5.000 4.000 140. As a result. and lent assistance to another thirty that were in difficulty. brokered buy-outs.000 2. increasing the number of bank offices from 8. thereby protecting the consumers which banks serve and the economy which the industry supports. The collapse of a major financial institution.000 80. In this case. or THE EvoluTion of financial sErvicEs 67 . or automobile manufacturing) are neither so fundamental to the economy nor so critical to the livelihood of the consumer.000 500 1865 1869 1873 1867 1881 1885 1889 1893 1897 1901 1905 1909 1913 1917 1921 1925 1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 Deposit insurance per account ($) 200.016.500 4. These examples illustrate the extent to which regulators can influence the evolutionary process of financial services. Similar interventions by the authorities can be seen to have affected the number of banks in developing economies.000 3. Companies in non-financial industries (computing.500 1.000 120.000 40. In newly independent India.500 3.000 20.000 1. is an event which any regulator (and politician) wishes to avoid at all costs – a fact of which British authorities were painfully reminded in September 2007. the authorities encouraged mergers and acquisitions.000 160. the number of reporting banks declined from 517 in 1952 to a low point of 90 in 1967.
The uS had no central bank until the creation of the Federal reserve System in 1913. in fact. but not recognisably performing its modern role until after 1873. the year of Walter Bagehot's definitive Lombard Street. monetary authorities were constrained more by the largely unwritten rules of the game that governed the gold standard and by widely divergent national statutes. founded in 1694. One consequence of this special status is that deposit-taking institutions rarely outperform the sector average. however. performance differences among firms tend to be small within any given regulatory jurisdiction." the evolutionary process will be thwarted.outright nationalisations have been a regular feature of policy making since the 1930s and still occur today. appearing in developed countries at very different times (see figure 29). Compared with other industries. the Bank of Japan (1882) a product of the Meiji restoration. in short. From an evolutionary perspective. the German reichsbank (1875) a Bismarckian one. It is. regaining their independence only after the trauma of the 1970s inflation. The first true central bank (in the sense that it acquired de jure a monopoly on note issue and de facto the role of lender of last resort) was the Bank of england. and most central banks became little more than appendages of national treasuries and finance ministries. encouraging excessive risk-taking on the assumption that the state will intervene to avert illiquidity and even insolvency if an institution is considered too big – meaning too politically sensitive or too likely to bring a lot of other firms down with it – to fail. The Banque de France (1800) was a napoleonic foundation. the problem looks slightly different. Banks. undesirable to have any institutions in the category of "too big to fail". Before the First World War. legislators demand a relatively high level of regulatory supervision. poliCy CoNVerGeNCe AND reGUlATory iNDepeNDeNCe Over the long run. In return for their implicit or explicit guarantees to banks. do not behave like software companies. national systems of banking regulation have changed and gradually converged. The gold standard rules collapsed in the era of the World Wars. 68 . The experience of Japan in the 1990s stands as a warning to legislators and regulators that an entire banking sector can become a kind of economic dead hand if institutions are propped up despite under-performance (see box 5). The critical question that has raised its head once again in recent months is whether implicit guarantees to bail out banks create a problem of "moral hazard". because without occasional bouts of "creative destruction. The central bank is a relatively modern invention.
yet considerable differences of opinion remain as to the correct basis for the formulation and implementation of monetary policy. inflation targeting is more common as a goal of central banking. The eVolUTioN of CeNTrAl bANKiNG iN SeleCTeD DeVelopeD eCoNomieS SiNCe 1875 1875 1900 1925 1950 1975 2000 2007 US 1913: Federal reserve established Japan 1882: BOJ established. exchange controls and other restrictions on financial services were dismantled in most developed economies in the 1970s and 1980s. compared with 11 and 24 between 1960 and 1989 (see figure 30). and contrasts in rhetoric and in practice with the modus operandi of the Bank of england (which has pursued an explicit inflation target since 1997) and the european Central Bank (which under Jean-Claude trichet appears to retain at least a passing interest in monetary aggregates). respectively. Independence. Becomes LLR in the 1920s (after WW1) France Germany 1876: Reichsbank 1946: Bundesbank Italy 1893: Bank of Italy formed and given note issue monopoly in 1926 1936: Bank of Italy becomes true central bank Spain 1874: Banco d'Espana granted note issuance monopoly 1956:Banco d'Espana nationalised Switzerland 1907: Swiss National Bank established UK No central bank Quaso-central bank Full central bank Within the last twenty years.2. there has been renewed convergence at the level of policy setting and decision making. Committees of experts are more frequently used to set key short-term rates. measured by a set of criteria and scored from one to ten. The distinctly eclectic approach favoured by the Federal reserve under Alan Greenspan appears to be continuing under his successor. 23 and 26 central banks between 1990 and 1998. has increased across central banking organisations in the developed world. however. and central banks are increasingly independent from government. though developing markets still lag behind (see figure 31). The Fed takes an asymmetric view THE EvoluTion of financial sErvicEs 6 . Money supply targets and exchange rate targets were adopted by. compared with just 4 from 1960 to 1989. From 1990 to 1998 more than 50 central banks adopted an inflation targeting policy.
by contrast. is very far from complete. The european Central Bank. and thereby giving rise to the notion of the "Greenspan put" on the uS stock market. seeming to worry more about wealth effects on the way down than on the way up. the Bank of england was reluctant to inject liquidity into the markets on the ground that it would be bailing out reckless players. ADopTioN of exChANGe rATe. 30. with politicians in Britain and France openly criticising their respective monetary authorities during the recent credit market crisis. moNey. in short.of asset markets. injected significantly more liquidity more readily than might have been predicted on the basis of previous pronouncements. AND iNflATioN TArGeTiNG by CeNTrAl bANKS Central banks using target 160 140 120 100 80 60 40 20 0 1960s 1982 1986 1990 Money target 1994 Inflation target 1998 Exchange rate target Source: Sterne (2001) 70 . In August 2007. Convergence. Central bank independence remains a fragile construct.
laurens. Many central banks in the late nineteenth century were privately owned. and as such remained somewhat insulated from overt political influence. Between 1933 and 1940. The Financial Services Authority in London is of much more recent origin. the FSA took on its current form in 1997 at the same time as the Bank of england partially regained its independence in the determination of monetary policy. there was very little regulation. Indeed. no major change occurred to this legal framework until the passage of the Sarbanes-Oxley Act in 2002 which. financial markets and financial services companies were very loosely regulated by present standards. THE EvoluTion of financial sErvicEs 71 . CeNTrAl bANK poliTiCAl AND eCoNomiC iNDepeNDeNCe Index of Independance 7 6 5 4 3 2 1 0 Political independence Economic independence Not available Not available Political independence Economic independence Developed markets Source: Arnone. an independent. was enacted in response to a crisis (the wave of accounting scandals exemplified by the collapse of enron). Originally established as the Securities and Investments Board of 1985. like most such legislation. which the SeC was empowered to enforce. and Segalotto (2006) Developing markets 1991 2003 For most of the past century. non-partisan agency with quasi-judicial powers.31. it took some time for their directors to acknowledge the priority of their shareholders' interests. least of all in the uS where Hayekian free banking prevailed for most of the nineteenth century. Prior to the Great Depression. six major laws were passed relating to the securities industry. That changed in 1934 with the creation of the Securities and exchange Commission.
Banks were closed or suspended through much of 1997 and 1998. Sweden saw its entire financial system hospitalised from 1991 to 1994. left banks with large non-performing collateral-based loans when the bubble finally burst in 1989. however. The early nineties saw a tightening of lending requirements. putting aside a further ¥60 tn to support failing banks. In the mid 1980s. further impacting the quality of the banks' balance sheets. In the post-war period between 1945 and 1973. nobody saw it coming. But it has happened several times in recent memory. high economic growth and near zero inflation boosted asset prices to unprecedented levels. and Japan's famously collapsed in 1997. Savings were channelled into these banks and restrictions on other financing options made them the prime financiers. The 1970s. This. raising their funding costs above those of their clients. brought about regulatory changes that eroded their power base and left the Japanese banking system in turmoil. Many banks complied with Basel I at the time of introduction. The government also injected ¥1. Banks' ratings declined. coupled with aggressive lending in a bid to capture market share. Larger Japanese corporations once reliant on bank financing shifted to the bond markets.box 4 – The JApANeSe bANKiNG CriSiS Sometimes it can be difficult to remember that large. but many problems were simply disguised: non-performing loans remained unnoticed. problem loans were moved to related companies whose financial status was not consolidated. 72 . as did other investors looking for more attractive and easier options for financing and investment. using shares on the balance sheet to constitute much of the capital. as they were simply restructured and reclassified. The reform process saw the deregulation of financial markets and easing of restrictions on the issuance of equities and bonds.8 tn directly into banks. Japanese banks turned their lending priorities to individuals and the commercial real estate industry. Japanese banks enjoyed a position of pre-eminence. Clients began issuing debt rather than borrowing. Sticking to their traditional lines of business. convertible bonds were issued to improve the capital position of banks. well-capitalised and apparently stable banking systems can completely collapse. which are generally risky in nature. Banks began to enter insolvency in 1997 as depositors aggressively removed deposits from weakened institutions. despite government guarantees. Though the reasons for the collapse seem fairly obvious now.
it would be foolish to believe that the list of the top ten banks in 2017 will resemble that of 2007. values of some banks turned negative when they were asked to increase their provisions on certain portions of the book. to be replaced by Chinese banks. In September 2003. THE EvoluTion of financial sErvicEs 73 .The Financial Supervisory Agency was set up and conducted a series of onsite evaluations of banks. mitsubishi UfJ financial Group iCbC royal bank of Scotland Credit Agricole export-import bank of Japan Sumitomo bank Union bank of Switzerland Deutsche bank Citicorp bank of Tokyomitsubishi Deutsche bank bankAmerica Corp AbN Amro bank 5 6 7 8 9 Swiss bank Corporation fuji bank Sumitomo bank Dai-ichi Kangyo bank bank of China 10 Santander Source: The banker Following the crisis. concluding that their credit quality was massively underestimated. Japanese banks still had an estimated ¥21. 17 AND 2007 1987 1 barclays bank 2 National Westminster bank Citicorp 4 hSbC holding Chase manhattan Corp Agricole Group 1997 2007 bank of America Corp Citigroup 3 hSbC holdings Credit Agricole Group Jp morgan Chase & Co. WorlD'S Top TeN bANKS by Tier oNe CApiTAl iN 187. Japanese banks all but disappeared from the list of the largest banks in the world. Though banking crises in developed markets are by no means common.5 tn of non-performing loans for which they had not made any provision.
in practice. with mixed results. it is not surprising that the impact of regulation has been. More level playing fields actually favour the least efficient incumbents. but efforts to establish a regime to govern global capital flows (the way the World trade Organization governs trade) have so far proved fruitless. exchange rates since the collapse of the Bretton Woods system in the early 1970s have been determined by central banks on a largely ad hoc basis. What is an enlightened regulator to do? What can a wellmanaged firm reasonably expect the regulators to do? In the next chapter. Increasing transparency can punish innovators. we seek to draw some conclusions from our evolutionary account for the sector and to offer some medium-term guidance for financial service providers and regulators. at best. encouraging new entrants creates new risks. efforts to create an international regulatory framework for financial services continue. Investor protection can lead to prolonging the life of failed business models. many of which overlap and are inconsistent with each other. It remains to be seen what the effects will be of the transition from Basel I (agreed in 1988) to the more sophisticated rules of Basel II. The principles of Darwinian natural selection can. with only occasional collective "accords. too.At present. Protecting the consumer adds cost indiscriminately to all providers. as competition between different financial centres (notably new york and London) has led to pressure for harmonisation though the lustre of Britain's "principles-based" approach has been somewhat tarnished by the northern rock debacle. Given all this. Here. The World Bank and the International Monetary Fund offer some kind of international structure for sovereign borrowing by poor or crisisstricken governments. mixed. apply to regulatory frameworks as well as to financial services providers. most financial regulation is national in character. 74 . oVerVieW The global financial services industry operates under a multitude of legal and regulatory frameworks. regulators seem to face a number of conflicting objectives." The most important international regulatory advance has related to bank capital requirements and has been carried out under the auspices of the Bank for International Settlements. However. in theory. no dominant "intelligent design" can hope to emerge in a context where there are no universal metrics of success and where political interference is a regular occurrence. which are due to be adopted by at least 95 national regulators by 2015. we see an evolutionary tendency.
our historical approach offers an adapted version of evolution as a framework for understanding the development of financial services. First. We draw practical lessons about financial services of the future and apply them to a few concrete problems that the industry faces today. neither evolution nor financial services has a single. Objectives differ across geographies and end-user segments. In the late 19th century. Far from converging towards a single performance measure. evolution ensures that there will continue to be speciation among service providers. It does not aim (as used to be thought by anthropocentric victorians) to produce homo sapiens as the finished product of life on earth. In short. when most financial institutions found themselves subordinated to national plans for wartime destruction or peacetime reconstruction. and are often conflicting even in the same segment. long-term objective function. it is impractical to define the desired end-state of financial services through a finite number of objective metrics. inherently. In both financial and biological evolution. for example. AN eVolUTioNAry frAmeWorK There are three fundamental reasons why we see evolution as a better framework for understanding financial services. prefer certain species or attributes to others. Some microfinance lenders. Altogether different priorities dictated the evolution of finance in the 1940s and 1950s. no formula works forever. evolution does not have a purpose and does not. closely followed by the mobilization of small savings into the bond market via savings banks. the German "three pillar" system 5 evOLutIOnAry LeSSOnS In FInAnCIAL ServICeS THE EvoluTion of financial sErvicEs 75 . for example. Second. the facilitation of trade and gold convertibility were paramount objectives. the sole common objective is to avoid disappearance. In this chapter. we describe the main elements of this framework and then apply it to make sense of historical facts and apparent paradoxes. others are in business to help the poor. Structures that were highly successful in the past – for example. Species that prosper and seem indestructible for long periods can still fall victim to competing species or environmental changes.Going beyond superficial Darwinian analogies. just as there will be increased diversity among end-users. Money can change hands in a multiplicity of ways for a multiplicity of purposes. The provision of financial services does not have a single end-goal either. This is also fundamental to financial services: There is no perfect provider type (or regulatory framework) that will remain successful and dominant into the future. are in business to make a profit.
Third. highprofit segments of the industry exist as a result of small changes – either proactive experiments or reactions to external stimuli – that then led to the creation of new markets or new ways of delivering traditional services. the less robust it gets if the result of its success is that variance declines. technology advances. the harder they fall". perturbations arise from the human element. stay very high for long periods as in the case of large loss insurance during the 19th century. As with evolution. Barriers to entry may. 76 . inter-connectivity. Without ongoing change. that was the root of the problem in 1980s Japan. and exposure to external forces. Indeed. as the socialist theorists of a century ago imagined. the tendency would be to drag financial services down to the lowest common denominator. the majority of mutations are unsuccessful. Perhaps there really would be consolidation and convergence into one vast global monopolist. over the long term we see greater diversity and higher rates of innovation in financial services. but without them the end result would be stasis rather than the vibrancy that we observe. However. and the economic environment changes. an important similarity between financial services and an evolutionary system is that the more successful a form becomes. In financial services. We estimate that over half of today's high-growth. In practice.of banking – eventually come under pressure and decline in their effectiveness. mutation is built into the system. or the current scale game in custody services. indeed. seemingly failsafe formulae stop working as alternatives surface. Sometimes it really is the case that "the bigger they come.
Continued evolution Pool of forms Time (decades) A further important point is that the stakeholders in financial services are also part of the evolutionary process of change. Over a long period of time. stable objective Spontaneous new Adaptive Extinct No convergence.These fundamental forces set up a dynamic environment that continues to generate new forms both randomly and (unlike in natural evolution) through conscious adaptation to external changes. THE EvoluTion of financial sErvicEs 77 . overlapping shifting objectives Mutation No formula works forever No single. the needs and preferences of end-users. Rapidly changing environment Multiple. employees and investors change as greatly as those of financial service providers and regulators. The table below gives a few examples of broad changes that have happened over long periods and that have set off new internal dynamics within the framework.
scale manufacturing. and as ultimately doomed forms are kept alive in "sanctuaries" Creates randomised speciation opportunities and elongates certain extinction trajectories mass retail agenda not shifting from consumerism to old-age provision young generations expecting joined-up technology solutions to all financial needs Governments facing implicit longdated expenditure demands financial services firms have become technologically irrelevant. despite spending 20-50% of their cost base on technology and operational processes Cost of "bespoke" modules will spiral. places traditional Sme models on the endangered list encourages captive wealth managers as a new evolutionary form. while cheap whole platforms will lose distinction Service provider agenda (to consumer financial service providers) shifting from micro- product provision to platform outsourcing Top-end employee preference shifting from tenured salaries to profit/equity ownership Difficult for intellectual capital businesses in financial services to deliver consistently to shareholders investors attaching higher premium to "owner-like" managers regulators increasingly regarding the status quo as a good in itself Traditional asset managers (especially "active" ones) losing market share rapidly pockets of suppressed evolution co-existing with market-driven forms will impose significant hidden costs on "protective" domestic macroeconomies A new source of largely inexpert capital will further reduce cost of capital on an arbitrary basis Sovereign wealth funds reemerging and becoming more actively involved in financial services 78 . can create hidden regulatory problems forces sharper distinction between customised distribution firms vs. opens up vast parts of the industry value to alternative providers and alternative investors explicit or hidden "public-toprivate" forms emerging in financial services – will favour advisory boutiques and firms that tolerate high pay-out ratios to producers Catalyst for a whole new wave of alpha-driven asset managers. by nature these are more transient and more volatile Net loss to the system as superior forms are excluded from large parts of the environment.Internal change Small- and medium-sized enterprise focus shifting from working capital financing to strategic advisory Super-wealthy agenda shifting from wealth creation/protection towards addressing global issues Pressure points banks had invested in expensive distribution but their core product – credit – has lost relevance private banks and wealth manger solutions woefully inadequate for the truly rich Impact on evolutionary process encourages new forms of direct lending to Sme segment. strengthens chances of not-for-profit organisations to increase market relevance Shifts evolutionary momentum from investment sales to individuals towards financing state institutions opens up major parts of traditional financial services to tech-savvy provider forms.
hedge funds Do not waste resources on controlling evolution.to illustrate the power of this framework. so that the results of any stimulus can be predicted with enough information. interdependent and shifting over time most useful when stable relationships are observed between causes and effects formulaic and subject to stages of development powerful when range of outcomes is more important than specific outcome scenarios randomised with directional progress and significant nonpredictable variation around the mean random so that unexpected successes and failures are the norm irrelevant unless certain groups can re-shape underlying stochastic processes pattern-less drift through future macroeconomic and environmental scenarios observed in rapidly expanding new market sectors where no clear winners can be discerned yet Create insurance mechanisms against the extreme downside scenarios and plan responses in an inherently random world Demand structure Supply structure formulaic and resulting from shifting prices of factors of production owners of factors of production (human. with no convergence possible Deterministic An adaptive system where a number of fundamental rules prevail. create transparency and level playing fields to the extent possible Relevance to today's financial services world So what if it is right? THE EvoluTion of financial sErvicEs 7 . Evolutionary Overview A dynamic equilibrium where all aspects of the industry evolve due to a complex set of drivers. e. and – given enough time – a static equilibrium can be reached Stochastic A randomised system where responses to events are drawn from explicit or implicit statistical functions and where no equilibrium is possible Fundamental drivers Current pool of forms mutation lack of single objective No stable formulae Uncertain outcome of environmental impact Underlying set of rules linking inputs to outputs external inputs Underlying set of stochastic functions linking stimuli to responses Applicability most useful when there are both long-term trends and short-term effects in play Dynamic and driven by both external and internal economic and other needs Dynamic and subject to adaptation and spontaneous creation / extinction Complex.g. financial and infrastructural capital) as the key determinants inexorable drift towards a stable equilibrium where a complex objective function is maximised observed in highly planned economies and/or highly regulated domestic finance sectors Continuously look for the "grand rulebook" that defines a successful finance industry Stakeholder hierarchy Endgame Continued dynamic equilibrium that sees adaptation and creative destruction on a syncopated basis most clearly observed in least regulated parts of the industry. it is instructive to compare its features with two alternatives that have been implicit in the observations and actions of many industry participants.
to see how far we have left the consensus view behind. we demonstrate the usefulness of the evolutionary framework by applying it to past events. There is no guarantee that volatility will not return with a bang in the decade ahead. The period from 114 to 17 revealed the ease with which integration could be reversed and the difficulty of restoring it past technological innovations have not always translated into major gains in financial sector productivity The 'new' ownership structures seen today are not significantly different from those seen throughout history The financial system is not necessarily more stable today than during the laissez-faire era of the late nineteenth and early twentieth century Liquidity and global integration Demographic change Unsupported Unsupported Global imbalances Unsupported Technology and productivity Risk management Ownership Unsupported Supported Unsupported Regulation and supervision Unsupported mACroeCoNomiC STAbiliTy relative macroeconomic stability has been a hallmark of the last decade. but the dependency ratio is not close to its historic high The world has been very globally integrated before – as integrated as it is today. 80 . today's stability resembles that prior to the first World War liquidity. though growth in the first age of globalisation was admittedly somewhat lower and more volatile. current challenges and the future of the industry. but in the context of history it is relatively unspectacular. has been higher before and has disappeared suddenly in past crises Society is beginning to support an increasing number of dependents. DrAWiNG leSSoNS for The fUTUre Let us now review the principal environmental and evolutionary tendencies. Most measures show the world economy to have been equally dynamic at the end of the nineteenth century. though high today.In the following sections. Consensus view Macroeconomic stability Unsupported Shortfall versus evolutionary perspective macroeconomic instability was a hallmark of the mid-twentieth century. no doubt.
at least by some measures.liqUiDiTy AND GlobAl iNTeGrATioN Though undoubtedly higher today than it was 20 or 30 years ago. it may be suggestive of a broader change. This is the sense in which the financial world today is awash with liquidity. THE EvoluTion of financial sErvicEs 81 . given that the value of the CDO tranches. The increasing liquidity of assets other than cash and deposits means that using the money supply as a measure of overall liquidity can give an incomplete picture. especially those secured on sub-prime mortgages. Here we use another definition of liquidity: the ease with which an asset can be bought or sold on the stock and bond markets. This reduced the ability of banks to measure their own potential losses and each other's potential riskiness. albeit in negligible volumes compared with the universe of real estate and the trade in other liquid assets. The lesson is clear: Liquidity can disappear very suddenly from a segment of the financial system. Though this metric measures just one aspect of liquidity. but they are now edging upwards again. bid-ask spreads have fallen considerably since the early 1990s (some of which can be attributed to technological improvements in trading systems). even real estate is now traded through reIts on stock exchanges. SIvs. a number of banks and other institutions that held CDOs found themselves in such difficulties that central banks were forced to act not only as providers of liquidity but also as lenders of last resort through the discount window. the secondary market having all but collapsed. liquidity is not exceptionally high in a longer-term perspective. even the tranches classified as AAA by the rating agencies. The current turbulence in the credit markets points to just such a downturn in the liquidity cycle. nevertheless. The stock and bond markets have outgrown the money supply. even at a time when it seems to be abundant in the system as a whole. recent events have exposed the potential for acute illiquidity in new markets that have arisen outside the traditional framework of the stock and bond markets. have proved to be potentially highly illiquid. CDOs. and conduits they held had become impossible to measure. In August 2007. Peer institutions were unwilling to lend. the evolution of capital markets has meant that more and more assets have become liquid in the sense of being quickly and easily tradable at a market price. and are larger as a proportion of GDP today than they were a hundred years ago. As figure 32 shows. Moreover.
50% 2. however. The liquidity metrics driving the downturn vary on each occasion.00% 1. During the summer of 2007. May 1994.00% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: Datastream.00% 0. slowly expanding thereafter (figure 33). AVerAGe biD-ASK SpreADS oN WorlD SToCK exChANGeS Contraction Contraction Contraction? 2. World federation of exchanges.50% 0. while in 2000 it was the money supply that fell sharply.50% 1. 33. oliver Wyman analysis Our own measure of liquidity also contracted during the volatile markets of 1997 and 2000. August 2007 1994 2007 Source: Datastream. oliver Wyman analysis 82 2007 . liqUiDiTy DUriNG TimeS of CriSiS Oliver Wyman Rebased to 100 at liquid peak 120 110 100 90 80 70 60 50 40 30 Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 2000 Month 7 Month 8 Month 9 Month 10 April 2000.32. bid-ask spreads and short-term money market rates were strong indicators of the downturn.
11 November 2004 THE EvoluTion of financial sErvicEs 83 . the less protracted crises tend to be. There was no real reason prior to the summer of 2007 to believe that this cycle had been abolished. however. Bid-ask spreads widen and interest rates rise as money becomes more scarce and expensive. financial Times.each peak signifies a drying up of liquidity. "Why we should worry about liquidity". The three peaks in correlation during the twentieth century occurred during and prior to the First World War (Globalisation 1. in short.It was notable that all stock markets were negatively affected by the August credit crunch. although it is quite integrated today. during the Great Depression and again today (Globalisation 2. the potential for contagion is arguably higher than ever. and open economies can return to growth much faster than closed ones. On the other hand. and all responded in unison to the accommodative moves of the Fed and the eCB. Further integration in the coming decade. would take us into uncharted waters.21 Central banks tend to act as lenders of last resort to their national (or.0). in the case of the eCB. global integration has attendant risks. even in times of relatively low global integration. the more integrated economies are. regional) markets. the susceptibility of globalisation periodic and highly correlated crises remains a critical feature of the macroeconomic environment. By injecting liquidity into the market. 21 Sir Andrew large. nevertheless. Stock markets have shown remarkable levels of correlation with one another in times of prosperity and during extreme crises (see figure 34). to be sure.0). central banks enable financial services organisations to cover positions without incurring large losses. As we have seen. major financial crises can quickly spread across borders. may be more susceptible to contagion than a non-integrated one. yet globalisation means – and certainly meant last summer – that a liquidity crisis in London can have an impact on other financial markets. An integrated global economy. Capital is able to move to affected areas much faster and in greater quantities. as trade helps fuel demand when domestic consumption is weak. global financial integration has the great benefit of allowing the savings of Asian and Middle eastern economies to be channelled into the debt markets of countries with a higher propensity to consume. Clearly. the world economy is not exceptionally integrated in the context of the last hundred years. The capacity of central banks as lenders of last resort is critical during these stages in the cycle. In today's world.
The major impact of demographic change will be a shift in the way that society's dependents are supported. UK.0 0.4 0.0 -0. Correlations are for US. whose share of the world's working age population is expected to increase from ~80% today to ~90% by 2050 (see figure 35).6 0. GlobAl SToCK mArKeT CorrelATioNS Correlation of world stock markets 1.2 1870 1878 1886 1894 1902 1910 1918 1926 1934 1942 1950 1958 1966 1974 1982 1990 1998 2006 Ten year correlation Twenty year correlation World War I World War II Source: Global financial Data. france and Germany plus Japan from 116 DemoGrAphiC ChANGe High dependency ratios are nothing new. but there is a difference between a youthful society and an aged society. 84 . rather than a crisis resulting in the cost of dependents becoming overwhelming.2 0.8 0. Current demographic trends clearly favour the economies of younger developing countries.34.
taxation. oliver Wyman analysis Developing country share At the country level. The legacy of China's one-child policy will clearly create a major difficulty for that country in the foreseeable future. several potential obstacles to the unfettered growth that the financial services sector is now experiencing in China. it would become the only country in history to have industrialised without one. there may well be individual pension fund crises in developed economies. GlobAl imbAlANCeS It is widely taken for granted that the growth of the economies of China and India is unstoppable. China has come a long way in terms of recapitalising its banking system.35. as the dependency rate soars. DeVelopeD AND DeVelopiNG eCoNomy ShAre of WorlD'S WorKiNG AGe popUlATioN Forecast 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 0% Developed country share Source: UN. With balance sheets expanding rapidly as the economy booms and large numbers of retail and commercial customers THE EvoluTion of financial sErvicEs 85 . But the fundamental approaches to capital allocation and risk management remain unreconstructed in many cases. there is the potential for a regulatory backlash aimed at checking these trends. There are. risk measurement capabilities have considerably improved. As profit margins rise through innovation and scale benefits. or other barriers would all slow the growth of the industry. today. that proportion could have risen as high as 24%. however. Capping of interest rates. If China were somehow to avoid a serious financial crisis in the next decade. By 2050. It has made (and is still making) a series of welcome and crucial reforms. and that the financial services sector in Asia will grow proportionately to or even faster than the economy as a whole. less than 8% of China's population is 65 or older.
in short. As we have seen. including a sudden. let us now turn again to the evolutionary processes at work within the financial services sector. It seems reasonable. Both of these perspectives. The possibility exists that the computer revolution has done most of what it can do to improve productivity in financial services. a longer-run view suggests that technological innovation is not guaranteed to generate productivity gains on the scale we have witnessed in recent decades. difficulties seem certain to arise. This scepticism may be consistent with the observation that many new financial service providers are relatively small entities (like hedge funds and private equity partnerships). despite the fact that the first half of the twentieth century witnessed exponential technological advances in a wide range of other economic sectors. to a large extent these firms deal with their investors and targets of investment opportunity on a personal. nevertheless. Though all make some use (and a few make a great deal of use) of computerised trading systems.begin using financial services. The long-term perspective makes us aware of a whole range of ways in which the global economy could suffer setbacks in the decade ahead. major revaluation of the yuan or a crash of the Shanghai stock market (which at the time of writing. Having reviewed the prospects for the global environment. encourage us to expect continued rapid innovation. TeChNoloGy AND proDUCTiViTy There are two schools of thought about the impact of technology on financial services: either they treat technology as an external given that comes from outside financial services and impacts everything including that industry. is exhibiting distinctly bubble-like characteristics). face-to-face basis. to assume that the near future will not necessarily be like the recent past. or they see innovation as an amorphous mass of experiments that are partly endogenous. The relationships involved are unlikely ever to be automated in the way that the relationships between a retail bank and its account holders have been in recent years. 86 . nevertheless. A financial crisis in China could be triggered by a number of different events. there was very little technological innovation in financial services until the 1960s and 1970s.
generate more banking profit than any other product. but also by allowing hedge funds and other investors actively to trade credit risk exposure in a way never possible in the past. capital. more effective. It is in this area that risk management has evolved the most over the last decade. Here we are very clearly in new territory without historical precedent to guide us. Derivatives growth over the last decade has been driven more by credit products than by market risk products. nevertheless. Though syndicated loan trading increased hugely during the 1980s and 1990s. CDS purchases have grown especially quickly (though they make up a small proportion of total derivatives sales). of which CDS account for ~$30 tn. and derivatives markets has enabled the management of credit risk to be much more efficient than in the past. A liquid market for bank-originated assets enables much faster. THE EvoluTion of financial sErvicEs 87 . while the market for CDS was still tiny as recently as 2000 (see figures 36 and 37). notably the uS. MBS are much more actively traded and considerably more liquid. and in some markets. and cheaper risk management. products that were effectively non-existent as recently as 1980. As commoditised and homogenous securities. The use of derivatives has also increased significantly. not only by allowing banks to hedge and manage credit risk (historically the most frequent cause of bank failures). the current ease with which credit risk can be managed would have been hard to imagine even then. Though direct sales of loans (including the entire books of banks in financial difficulty) are nothing new. total derivatives outstanding were negligible in the mid 1980s compared with today. to be sure. investors' appetite has grown dramatically for secondary loans and other financial assets originating at banks in the form of MBS and ABS. total OtC derivatives outstanding amount to ~$400 tn. it is only recently that an active secondary market has developed for securitised products (though secondary trading in syndicated loans was common during the 1980s). the transition away from traditional balance sheet banking is by no means complete. let alone a hundred years ago.riSK mANAGemeNT risk transfer through more developed cash. largely due to rising demand from banks stemming from the introduction of the Basel II regulations. Deposits remain the single most important source of bank funding worldwide. which also began to grow rapidly in the 1990s.
is that the benefits of these innovations will continue to outweigh the costs that were revealed last August.000 350. biS Foreign exchange contracts CDS Other Equity-linked contracts 37. oTC DeriVATiVeS oUTSTANDiNG National amount outstanding ($BN) 450. financial institutions that fail to exploit the new financial 88 .36.000 5.000 25.000 0 2001 Source: iSDA 2002 2003 2004 2005 2006 It is not difficult to visualise a future in which banks have fully separated the management of the asset side of the balance sheet from the origination of assets in the market. As the stalling of credit markets during the summer of 2007 revealed.000 10.000 0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Internet rate contract Commodity contracts Source: iSDA.000 200.000 250.000 300. the movement to full separation of risk origination and balance sheet management in banking is far from complete.000 30.000 50.000 20.000 15. Our sense. oTC CDS oUTSTANDiNG National amount outstanding ($BN) 35. nevertheless.000 150.000 400. In evolutionary terms.000 100.
First. we feel that the conventional wisdom is validated by our long-term survey of the financial evolutionary process. while in Asia the South Korean chaebols and their financial services subsidiaries are becoming ever stronger. increasing their global market share. when reflation of balance sheets often strains to the breaking point less well-capitalised companies. State-owned banking organisations are certainly less common today than they were fifty years ago. appears to be enjoying a resurgence. Moreover. this may prove to be the beginning of a fundamental change. which is already viscerally suspicious of private equity. the move towards more active institutional investment could itself create some second-order effects. positively support moves by the latter with respect to specific investment decisions (as we have already seen happen in cases such as the ABn AMrO takeover battle). is the evolution of a symbiotic relationship between the large institutional investor species such as pension funds and insurance companies and the new species of more agile. by contrast. oWNerShip nothing better illustrates the degree of diversity in the financial services sector than the variety of structures of ownership that currently co-exist. more volatile employment markets may create potential backlashes from organised labour. aggressive investors. at the expense of more passive institutional investors. in the same way that many of the most important financial services companies of the early twentieth century were also privately owned. more and more smaller organisations are now very commonly privately owned. at a time in the cycle when bank finance is less available. as a consequence of tighter financial management. Third.technology and risk management are almost certain to lag behind their more adaptive competitors. companies at the margin may become less able to withstand financial pressure in periods of post-recession recovery. in our view. Though ownership of the largest financial services organisations is now almost exclusively through joint-stock structures. in the short term. companies in more open national or regional markets may create even more value and therefore be better equipped to grow beyond these markets. But conglomerate ownership of financial services operations by the likes of Ge. The former will either acquiesce in or. Second. One scenario is that activist investors might attract an increasing share of collective savings. more likely. In this one respect. THE EvoluTion of financial sErvicEs 8 . retailers and manufacturers are also entering the markets for banking and consumer finance in europe. More probable. If private equity and other active investors demonstrate consistently superior returns in more difficult economic conditions.
supervision. They cannot change the macroeconomic context. the financial services sector is more resilient to external shocks. but they also have limited power. indeed. Indeed. since it risks the prolonged survival of the 0 .e. The shortcoming of the consensus view is. systemic risk management and financial stability. under a stochastic model. Countrywide in the uS and IKB in Germany are just the latest examples. this is more a serious problem than moral hazard. past mistakes should. "events" belong in the tails of the probability distributions that govern everything. This is a very different regulatory/supervisory agenda from traditional models. regulators seem increasingly to be running the risk of preventing creative destruction from ever happening in regulated finance (i. try as we may to avoid them. which tend to be focused on consumer protection. policymakers are simply creating a pipeline of future "failures" which – in reality – are failures of expectation rather than of the regulatory framework. embedded in its fundamental precepts. This model predicts that there will be new and different types of external and internal shocks to come. Major firms continue to get into difficulties in highly developed economies despite all manner of regulation. In our view. again. A clear implication of the evolutionary model is that none of these traditional objectives of regulation can be achieved at all times. as the industry keeps experiencing new shocks that surprise the most seasoned participants.reGUlATioN AND SUperViSioN The mainstream view is that by learning from the past and having better policy tools. What they can do is to act as the guardians of transparency. today. help to create better solutions in the future and – over time – the whole system should indeed be made more robust by the repeated application and refinement of such solutions. and to help accelerate moves back to market normality when manageable shocks occur. This view seems highly dubious. that past responses to these shocks will not necessarily work. regulators and supervisors therefore have a privileged position in the system of financial evolution. and systemic protection – northern rock in the uK. and until the shapes of these distributions change we should expect the same types of shocks as we have seen in the past and – having lived through the previous ones – should be better prepared for the future ones. under the evolutionary model. the expected outcome is different. nor the fundamental forces driving financial services and other sectors. and that large-scale changes will be seen in the industry landscape. which posits that no formula works forever and that there is no single objective function. to generate early alerts of specific negative scenarios. by setting up such objectives for regulators and supervisors of financial services. banking). neither of these models generates the right answer here. under a deterministic model.
so long as new entities (hedge funds. We would therefore be firmly against any significant extension of the regulatory pale. On the other hand.unfit. the sector as a whole will remain dynamic. despite the repeated calls from American and european politicians for tighter control of hedge funds and private equity. THE EvoluTion of financial sErvicEs 1 . private equity) can arise and operate outside the pale of regulation.
could be forgiven for treating it merely as an interesting historical treatise.g. This plays out in multiple ways for the top leaders of a firm. These usually manifest themselves as hugely attractive markets that are highly protected (e. As a chairman of a bank or insurance company. or very low risk (e. If you allocate capital according to old models that do not reflect economic risks. industry leaders including chairs of supervisory boards. top management needs to be aware of "unnatural habitats" created by either too little regulation. natural is best. customer franchise) according to esoteric internal lenses that drift far off the external world. as in the biological world. The take-home here is not simply grow or die. diversify or perish. based on building incremental capabilities. that many industry participants currently face. Such markets are decoupled from economic reality. the evolutionary theory of finance does not offer conventional lessons to practitioners. Lesson 1 – Keep it natural In finance. it will lose its best people because the market certainly makes such distinctions. are you presiding over the creation of an entity that is evolving logically relative to its current form and available habitats? Another aspect of "keeping it natural" is to make sure your internal rules reflect the rules of the real world. By contrast. "natural evolution". CeOs and heads of strategy. it leaves the door open for many new entrants. or even through spontaneous creation of a small. stick to your core knitting or unravel – alluring though such simple mottos may seem. countries where the state always bails out companies for political reasons). works well and creates sustainable entities in a world that is inherently volatile and instable. innovative fast growth firm. As with most new paradigms.prACTiCAl leSSoNS for iNDUSTry leADerS In reading the above. economic capital. too many financial services providers fall into the trap of managing their key resources (human talent and their time/energy. If a payment processor deploys technologies that treat all customers as the same average customer. you will lose volumes or value or both. Finally. or the wrong type of regulation. relying on them to guide a firm's evolution usually results in institutional forms that are highly vulnerable to the removal of the market anomaly. "forced evolution" – the type that creates a Frankenstein monster by bolting together unconnected entities with different DnA and metabolisms – invariably fails sooner or later. In this section we suggest some more profound lessons and apply them to a few of the problems. very high growth detached from fundamentals (e. markets and businesses. sub-prime mortgages and consumer finance).g.g. If a wholesale bank does not differentiate bonuses greatly between superb and average producers. 2 . investment funds. banking supervisors who discourage foreign entry into a country). This type of evolution can be through organic or non-organic growth.
insurers becoming alternative asset managers with third-party clients and many firms becoming "supermarkets". Many firms feel incomplete without this. for example. One large bank recently estimated that its annual exercise costs 500 person-years. mistakes. opportunities will present themselves – some real and some illusory. Santander bought two businesses from ABn AMrO. while poor distribution management is still prevalent in many european countries. it is astonishing that the same mistakes are repeated across different businesses. THE EvoluTion of financial sErvicEs 3 . different business cultures and different business models. In the financial world. wholesale banks becoming commodities traders. trade buyers all missed the Long term Credit Bank of Japan. and in some cases catastrophic. Over the decades. Along the journey.Lesson 2 – Evolution does not wait for industrial plans With surprising conformity. we must point out its most beneficial aspect. In an evolutionary world. too. Both behavioural adaptation and physical recombination can help you absorb their best features. They want to have both easily digestible "soundbites" and mountains of back-up information and research that capture and justify their grand strategic plans. They will have a different "DnA". Continuous. geographies and epochs. It means rewarding those that consistently deliver relative to market norms. the clever firm monetises these as it goes along but within a highly disciplined framework. your firm is in the middle of a journey and – since the end of the journey is too uncertain to be meaningful – evolving on the go is often the best strategy. If they had been grounded in the reality of a natural evolutionary path. the elaborate. The lessons of past real estate crashes don't seem to have been learnt. stepwise innovations beat grand (re-)designs every time. rather than those that have great plans and presentations. however. aspirational strategy has frequently resulted in false destinations: retail banks trying to become global investment banks. to make the most of the journey. More recently. none of these expensive mistakes would have been made. The idea is to carry out appropriate analysis that points to the optimal destination a few years out. selling one at a profit and hence acquiring an important asset in Brazil at no net cost. On the journey. It avoids costly. learning (copying if necessary) and adaptation are key. leaving a private equity firm to make a substantial return on it for its investors. That means finding the parts of your own businesses that provide real competitive advantage and learning from them how to perform better elsewhere. your firm will meet new life forms. Before describing some actions implied by this lesson. financial services firms continue to define "strategic visions" and annually updated "five-year plans". sustained superior execution beats the best-laid strategies every time.
the phenomenon of activist investors would not exist in its current. telcos. retailers. have largely been neglected and even systematically mistreated by many financial services providers. no wonder other species (direct/Internet innovators. more than any other factor. adaptability. Financial services firms have to attract and retain human talent. even a few decades ago. processing them and doing the same again tomorrow. Both encumbents and new entrants have seen the power of human ingenuity create whole new markets that did not exist before. customers are often regarded as little more than a necessary evil. Is your firm doing the right things to attract all three? talent. "your call is important to us". too many financial services firms have completely undifferentiated messages for these different resources: "People are our most important asset". unfortunately. too. capital. software providers. customers are shackled by switching charges and captive products. Instead of being offered truly valuable solutions for their longer and more complicated lives. This has changed. Customers. With robust internal governance. there is no effective corrective action from the board. the pyramid schemes in emerging economies and generally low satisfaction rates among most retail customers speak for themselves. discipline)? Do we over-reward under-performers and under-recognise superior performers in the name of "fairness"? Do we know the alternatives open to our best people and what might motivate them to switch their energies? Capital is as indispensable as talent. aggressive form. The mis-selling scandals in developed countries. customers and technological assets. healthcare and automotive companies) are invading the financial services market. the governance of many financial services firms has drifted off course to the extent that management priorities are mainly focused on job preservation and reward maximisation rather than on shareholder value creation – and. Instead of being wooed with better services and superior offers. has rightly come to the fore in recent years given that a stronger talent pool enables greater institutional adapativity. crucially. "We run according to shareholder value principles".Lesson 3 – Make yourself more attractive Both biological forms and financial services firms need the right type of resources to adapt sucessfully within their evolving environments. but to be attractive to investors takes a different set of attributes. Several key "genes" in the adaptive firm are associated with talent management: Is our leadership attracting or deterring the best? Do we have a culture that promotes all the other value drivers (innovation. much of banking and insurance used to be slightly brighter shadows of sleepy administrative factories – taking orders. 4 . Is your firm welcoming to investors? Does your leadership "think like capital"? Or are you betting that capital is so plentiful that you don't need to justify what you do with it? Perhaps the most fickle and elusive of all business resources is the customer.
Habitat loss is also a feature of the real world in finance. this "rent" is disappearing fast. even seemingly monolithic markets (e. THE EvoluTion of financial sErvicEs 5 . Large value skews are a persistent feature of most financial markets and should lead to a continuous hunt for the best habitats. Being present in the right markets is a big plus that can be managed over time. There is ample evidence that much of the demand for financial services is latent and either goes un-served or appears as self-provision. no-one can escape the environment that they are in. each with very different characteristics. research has shown that financial services revenues are driven by two fundamental factors: exogenous economic production and endogenous innovation. In simple terms.g. PayPal (payments) and MAn (retail hedge funds) – the take-up has been very fast. play a role too. mass retail in a medium sized-economy) are actually composed of several sub-habitats. By contrast. higher GDP growth rates and less equal wealth distribution are all big drivers of financial services revenues. each with its own features. The former is the key factor. such as regulation. higher GDP/capita. accounting for over two-thirds of growth. This creates a rich diversity of finance habitats. Pension provision. Many other factors. Cross-border payments in europe used to be a hugely lucrative business for commercial banks.Lesson 4 – Habitats are more important than competitors In financial services. when new services have been made available – often by initially small start-ups such as Capital One (credit cards). insurance and risk diversification are very large areas of potential demand. A key insight from our research is that habitat differentials are more important than competitor pressures in most of financial services. as in biological evolution. but the liquidity crisis of 2007 has clearly dealt a blow to that line of business. but with the advent of the single market. Structured products seemed like the "no-brainer carry trade" to those unfamiliar with the market.
Hedging such risks. a management team might suspect that it is the wrong species with the wrong genes and maybe the wrong habitat. So-called "six-sigma events" actually occur every decade or so in some part of the financial system. the above lessons are internally consistent guidelines for leaders who face a barrage of often conflicting advice and demands. Life insurers need to tap into the savings wallet of their clients. it is possible to grow capabilities that are still linked to the core of the firm but create new growth options. as in Goldman Sachs' experience in the credit crunch of 2007. Domestic retail banks need to build a platform that is better for their customers and that can go cross-border. CeOs and executive management teams who swim with the evolutionary tide are more likely to survive and thrive. it can be spectacularly rewarding for shareholders and employees. however. will create the financial services equivalent of homo sapiens at the top of the evolutionary tree. simply because there are so many distributions in play. Where this works.Lesson 5 – Buy insurance everyone agrees that large exogenous shocks – the economic equivalents of meteor strikes and ice ages – will happen again in the future. a lesson from evolution is that every survival strategy has its own extinction buried deep inside it. from a mature economy provider to an emerging markets player. Instead of committing such rash acts. The second type of insurance policy is to "become amphibian". monitor and report them regularly. Indeed. Credit card firms need to find cheaper. rather. has an immediate cost to the P&L and is often dismissed as "too expensive". the first is the most obvious and least palatable for those locked into quarterly earnings announcements: Pay a premium to someone who will cover the extreme risks in your business portfolio. The above is not a formulaic recipe that. they quantify. The temptation in such situations is often to attempt to turn the firm into something that it is not: from a universal provider into a distribution powerhouse. if followed to the letter. Such shocks occur at a much higher rate than previously believed. there are two ways of "buying insurance" against such shocks. In our view. from a broker to a principal investor. In some cases. 6 . Boards. Having lungs and gills can be a great insurance policy as liquidity ebbs and flows. boards should be much more proactive in requiring the explicit hedging of specific extreme risks in their firms. Most financial services firms in the world are not only aware of these risks. more stable customer deposits.
but an internally consistent set of processes that can be seen at work in markets past and present. With all the important drivers of financial services growth. the biggest drivers of all – BrIC expansion. Indeed. from macroeconomics to demography to innovation. mainly because its past reference period is too short and its assumed futures are too smooth. the next quarter-century will not be a linear extrapolation of the last one. risk transfer and high liquidity – will likely experience the highest volatility. It is the only plausible framework that describes the many – sometimes seemingly contradictory – aspects of the financial world over long periods. Most of the consensus view has been shown to fall short when it comes to providing future guidance.oVerVieW evolution is not just a metaphor for the state of financial services. THE EvoluTion of financial sErvicEs 7 .
0 before 1914. Long-term trends can be as slow-moving and predictable as demographic shifts in the developed world and growth in emerging Asia. is that this possibility of extinction cannot and should not be removed by excessively precautionary regulation. every shock to the financial system will result in casualties. In terms of global integration and liquidity. Those that successfully recognise the difference between the periodic "winters" (financial crises. "natural selection" will work fast to eliminate the weakest institutions in the market. For a short period. pp. 254 THE EvoluTion of financial sErvicEs . and what form they will take. the world is essentially repeating the experience of Globalisation 1. "This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted. for example. we have no doubt that Schumpeter's words remain applicable today. In certain dimensions we are little (if at all) more advanced than we were at the beginning of the twentieth century." "Creative destruction" means nothing less than the disappearance of "those firms which are unfit to live". however. as legislators and regulators react and politicians mark their ground by acting to protect the consumer. we really are in a new world. while on other measures we are truly in uncharted waters. The critical point. In terms of securitisation and the use of derivatives. The key to survival for any financial services firm lies in the ability to recognise the slowly evolving long-term trends at work. It is harder to predict when crises will come. on the other hand. bear markets and periods of low liquidity) and the epoch-defining "ice ages" (Great Depressions and inflations) will be those that succeed.22 Although there is much more research to be done on the long-run evolution of modern finance. Only the best prepared firms will weather the storms ahead without lasting damage. Constant vigilance and adaptability are the keys to survival. which will typically be absorbed by the successful. while at the same time preparing for the inevitable and unpredictable shocks that will occasionally strike. however. Most crises will also usher in new rules. As Joseph Schumpeter wrote more than seventy years ago.6 COnCLuDInG reMArKS examining the history of financial services and the macroeconomic conditions in which the industry operates yields some important insights into the current state of the industry. 22 Schumpeter (134).
r.W. S. Gartner... A. Sutch. Arno Press. richard (2003) A Devil's Chaplain: Selected essays by richard Dawkins.BIBLIOGrAPHy Alchian. London 100 . S. G. The Future of Banking regulation in Developed Countries: Lessons from and for europe. G. C. La métamorphose des Caisses d'epargne : l'évolution des Caisses d'epargne ecureuil de leins origines à la période actuelle. IMF Working Paper 06/228 Bátiz-Lazo. yale Gould. and Benston.L. 1990) Carter. norton & Company. rutgers university Press. "uncertainty. Oxford Dawkins. D. Weidenfeld & nicolson. richard (1989).) (2006). t. pp. 2005). university of Wales Press. Australia. A history of money: from Ancient times to the Present Day. no. united States of America. and the united States. united Kingdom. "Measures of Central Bank Autonomy". (2002). (2004). Germany. r. pp. 46. Olmstead.B.A. no. (2002). 289-328 Blanden.A. Hoboken nJ Kindelberger. G. Cambridge university Press. (1950). (1996). The Banker. new york Goldsmith. (1989). A Financial History of Western europe. vol. (1975). Latha Menon. Darwin (eds.S. Michael (1990). Oxford university Press. economist Publications. 140. Journal of Political economy 58: 211–222 Arnone. Cardiff Dawkins. Canada. evolution and economic theory". 5 (Dec. J. 776 (October. top savings banks: Finding common cause". no. The Historical Statistics of the united States: Millennial edition.P. Financial intermediaries in the American economy since 1900. (1986). 1 (2004).r. Japan. Cambridge Davies. H. B. "europe. (1984). The Selfish Gene. A. Les editions de l'epargne. A History of Interest rates. Japan. S. 23-56 Benink. London Homer. Institutions & Instruments.W. (1983). M. The Financial Development of India. Paris Goldsmith.. One hundred years of economic statistics.. and Wright. London Duet. Sweden. yale university Press. London Liesner. r. ed. Financial Markets. (2nd edn). W. France. Laurens and Segalotto (2006). "Strategic Alliances and Competitive edge: Insights from Spanish and uK Banking Histories" Business History vol. Haines. Allen & unwin.. W. Stephen Jay (1989). Wonderful Life: The Burgess Shale and the nature of History. Italy. 14. vol.
MA Obstfeld and taylor (2002). Palgrave Macmillan. Palgrave Macmillan. r. university of Chicago Press. von seinem Wissenschaftlichen Beirat. 1750-2000. Financial Institutions. t. D. Methuen. J. 1898 THE EvoluTion of financial sErvicEs 101 . Asia & Oceania. and Globalization". university Publishers. (2003). Frankfurt rousseau. Bordo. 1750-2000.r. and Private equity are Shaping Global Capital Markets. pp. "Globalization and Capital Markets". (4th edn).r. tayor and Jeffrey G. "Developments in Savings and Loan Associations". 1880-1962. S.r. 9. (2003). MGI. M. Basingstoke Mura. B. 1945-53. (5th edn). B. Asia and Hedge Funds.v. Basingstoke Mitchell. (1898). Angus (2003). (ed.r.r. The Theory of economic Development.) (1996). Cambridge. (2003). (1982). (5th edn). "Financial Systems. pp. Peter L. (1934).W. B. 373-416 Schiffer. "Why is economics not an evolutionary Science?". History of european savings banks. 1954). WissenschaftsfÖrderung der Sparkassenorganisation. J. (1954). MA Sheppard.). International historical statistics: Africa.K. 3 (September. San Francisco Maddison.McKinsey Global Institute (2007).K. An evolutionary theory of economic change. Palgrave Macmillan. vol. Harvard university Press.G. Cambridge Mitchell. Alan M. Fritz Knapp verlag. Cambridge university Press. The World economy: Historical Statistics. The Journal of Finance. "Inflation targets in a Global Context". (1988). Williamson (eds. Basingstoke Mitchell. (1971). in Michael D. London Sterne. and Winter. Cambridge. Quarterly Journal of economics. new york Schumpeter. F (1962). OeCD Mitchell. Globalization in Historical Perspective. International historical statistics: europe 1750-2000. and Sylla. Stuttgart nelson. The Modern Japanese Banking System. Harvard university Press. The new Power Brokers: How Oil. vol. Deutsche Bankengeschichte / herausgegeben im Auftrag des Instituts für bankhistorische Forschung e. richard (2003). H. G. nBer Working Paper 8846 Pohl. Chicago. no. B. International historical statistics: The Americas. economic Growth. H. Central Bank of Chile Working Paper 114 torgerson. British Historical Statistics. 283-297 veblen. The Growth and role of u. (1982). 12. (2001).
Intertek Group Plc and the national College of School Leadership Ignacio Sanchez. Inc. former Deputy Governor. former Danish Minister of Finance and eu Commissioner Carlo Corradini. The equitable Life Assurance Society. chief executives and academics – to enhance the pragmatic impact of our leading-edge ideas.Asiain Sanz vice Chairman of Banco Provincial. vice chairman of Marsh & McLennan Companies.ACKnOWLeDGMentS Oliver Wyman is a leader in financial services strategy and risk management consulting. former Chairman of the Supervisory Board and Chief executive of Deutsche Bank Mathis Cabiallavetta. Chairman of the Social and economic Council of the netherlands (Ser) and Member of the executive Board for InG Group Sir Andrew Large. Oliver. Bralver. and member of the Board of Directors of Banca IMI Professor Niall Ferguson. formerly Chairman and Chief executive Officer of natexis SA Vanni Treves. The members of the Oliver Wyman Senior Advisory Board are Rolf E. executive Director of the Master of International Business program and Center for emerging Markets enterprises. we also harness the varied experience of our Senior Advisory Board members – all with distinguished careers as regulators. Wyman & Company THE EvoluTion of financial sErvicEs 105 . Founder of İlkorur Advisory Services and chairman of Bati Insurance Company Alexander Hendrik George Rinnooy Kan. former chairman of the board of uBS Henning Christophersen. author of 'The House of rothschild' and 'The Cash nexus' Korkmaz Ilkorur. BBvA Chile. Chairman of the Supervisory Board of Salomon Smith Barney. Banco Continental and BBvA Colombia Charles N. Bank of england David Murray.. Harvard university. Chairman of Leonardo Italy. Chairman of the Board of Korn/Ferry International. Breuer. to complement this. former Chief executive of Commonwealth Bank of Australia Emmanuel Rodocanachi. at The Fletcher School of tufts university and founding partner. The breadth and depth of our work in financial services gives us deep insight into the issues our clients face and how to help them perform better.
The firm helps clients optimize their businesses. Oliver Wyman is part of Marsh & McLennan Companies [nySe: MMC]. risk management. and a Senior Fellow at the Hoover Institution.500 professionals in over 40 cities around the globe. Stanford university. and The Cash Nexus: Money and Power in the Modern World. A prolific commentator on contemporary politics and economics. Oliver Wyman is the leading management consultancy that combines deep industry knowledge with specialized expertise in strategy. tisch. 1700-2000. profeSSor NiAll ferGUSoN niall Ferguson is Laurence A. Professor of History at Harvard university and William Zeigler Professor of Business Administration at Harvard Business School. which won the Wadsworth Prize for Business History. niall Ferguson is also a contributing editor for the Financial Times." 106 .With more than 2. His numerous books include The World's Banker: The History of the House of Rothschild. which he wrote as a Houblon-norman Fellow at the Bank of england. operations. and accelerate their organizational performance to seize the most attractive opportunities. organizational transformation and leadership development. He is also a Senior research Fellow at Jesus College. Oxford university. improve their operations and risk profile.
without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein. tax.For more information please contact the marketing department by email at marketing. This report may not be sold without the written consent of Oliver Wyman. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants. in whole or in part. This report may not be reproduced or redistributed. Oliver Wyman has made every effort to use reliable. This report is not a substitute for tailored professional advice on how a specific financial institution should execute its strategy. The information and opinions in this report were prepared by Oliver Wyman. legal or financial advisers. THE EvoluTion of financial sErvicEs 107 . Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. express or implied. or for any consequential. up-to-date and comprehensive information and analysis. All rights firstname.lastname@example.com or by phone at one of the following locations: EMEA +44 20 7333 8333 North America +1 212 541 8100 Asia Pacific +65 6510 9700 Copyright © 2007 Oliver Wyman Limited. but all information is provided without warranty of any kind. special or similar damages even if advised of the possibility of such damages.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue listening from where you left off, or restart the preview.