The emerging picture

Despite the continuing signs of recovery, there remain some serious challenges ahead for the industry. As Brendan Nelson explains, clarity on what the true picture will be is an important step in identifying the opportunities for the industry.

It is clear that financial services will continue to face quite significant challenges for many years to come.

Perhaps the most unambiguous conclusion is that global economies do seem to be recovering, and that the worst appears to be behind us. Growth has returned to some of the developed economies, notably France and Germany in the eurozone, although the UK economy shocked many commentators by continuing to decline in Q3. In developing markets, too, growth is back, although the GDP upturn in China is still heavily dependent on investment rather than consumption. Most promising, the US economy exceeded expectations by recording GDP expansion at a 3.5 percent seasonally adjusted annual rate in the quarter ended in September.

So can we all breathe a sigh of relief and turn to pursuing the new opportunities arising after the crisis has passed? Not exactly. While there is no doubt that significant challenges and opportunities are emerging, the medium and longer term economic, regulatory and political setting against which these will play out remains fundamentally uncertain.

The financial services sector is on the back foot. Battered by blame and recrimination for causing a crisis which has triggered a major recession, it now faces unprecedented intervention from politicians determined to show they can avert the possibility of this ever happening again. So with the claimed benefit of the moral, political and financial high ground, many politicians are now contemplating one of the greatest extensions of regulation into financial services which the capitalist economies have ever seen.

Officials and regulators are competing to propose more and more radical change: break-ups of sound financial institutions as the price of state aid, to counter the too-big-to-fail problem; massive and counter-cyclical increases in regulatory capital requirements; direct constraints on compensation arrangements which would have been unthinkable a couple of years ago. Clearly the massive and concerted policy response to the immediate crisis stabilized the system and saved us all from disaster. But will the preventative measures now being considered themselves prove to be corrosive in the longer term?

Much will depend on the shape of the recovery, and how it might both be supported by the banking sector and impact on it. Peter Cornelius, Chief Economist at AlpInvest Partners¹, a leading independent private equity investment manager believes that increasing signs of imminent recovery, and improved business and consumer confidence, are reassuring. But longer term, the prospects for a return to historic growth trends are much more uncertain.

The substantial inflows of capital into stock markets in the US and UK have driven remarkable recoveries in share prices over the last six months, suggesting that investors are looking to a V-shaped recovery, with rapid collapse rebounding to equally rapid growth. Appetite for risk is returning. Asset price volatility has declined. Although the recession has been deep - resulting in the loss of trillions of dollars from global GDP - it has not been dramatically serious in the historical perspective.

Nevertheless, there are serious reasons for concern that events will not proceed as benignly. Experience shows that recessions triggered by financial crises are deeper than others, as are those following globally-synchronized crises. Recent events have combined both characteristics. A W-shaped (double-dip) recovery, or a long, slow upturn may be equally likely outcomes. The confidence now apparent in equity markets is in part artificial: with deposit interest rates at an all time low, investors, desperate to find yield somewhere, are perhaps bidding up equity markets beyond their intrinsic value.

Whether the eventual return to business as usual will imply a return to the historic long-term growth trend of around 2.5 percent per year is also a moot question. A number of factors suggest that a 'new normal' growth trend could take hold, significantly lower than historic levels. Households in the UK and US are still over-leveraged. Houses are still arguably over-valued. Unemployment will continue to rise: 7.2 million² jobs have already been lost in the US, and this will inevitably increase. Since the US consumer is one of the world's primary economic forces, disposing of US$10 trillion³ annually, prolonged consumption weakness here would act as a long-term drag on global GDP. If surplus economies - pre-eminently China - do not step in to take up the slack, and with consumption not investment, the 'new normal' may mean weak growth, if any, for the foreseeable future.

In the financial sector, many significant challenges remain. Substantial further asset write-downs are almost inevitable, both as the remaining toxic assets are flushed out of the system and the impact of weakened economies on loan books, driven down in value by the recession itself. Bank lending to business and consumers remains tight, and is likely to get tighter still. The enormous increases in government debt incurred in rescuing the global economy will be unsustainable for more than a few years: the result will have to be large increases in tax alongside major cuts in public expenditure. As quantitative easing is unwound, interest rates must rise. The specter of 'stagflation' - prolonged economic stagnation combined with rising inflation - could return.

In the longer term, a failure to repair the securitization model, in a responsible and sustainable way, could permanently deprive the financial system of substantial deployable capital.

Against this background, CEOs of financial institutions face enormous challenges. 'Business-as-usual' is likely to turn out to involve a whole range of new burdens as well. Banking and insurance executives - along with their advisers - are struggling to discern what the clamor for new regulation will mean in practice, and how politicians' rhetoric can be translated into measures which can actually be implemented in constructive and beneficial ways. How should corporate governance evolve? What should the role of the audit committee be? How can boards gain assurance beyond the traditional limits of statutory audit? How will accounting standards evolve? How on earth can responsibility and calm return to the issue of compensation?

It is a business cliché that challenges are opportunities in disguise. In the new landscape, clarifying what the opportunities are will be a challenge in itself.

Article author

Brendan Nelson
Vice Chairman,
KPMG in the UK
Global Chairman, Financial Services
+44 20 7311 6157 Brendan Nelson View all articles by this author

1. Previously: Group Chief Economist Royal Dutch Shell; Chief Economist and Director of the World Economic Forum's Global Competitiveness program; Head of international economic research at Deutsche Bank.
2. 'It will be years before lost jobs return - and many never will', Sudeep Reddy, http://www.wsj.com/, October 5, 2009.
3. 'US Economy: Consumer Spending, Confidence Fall (Update1)', Timothy R. Homan and Courtney Schlisserman,
http://www.bloomberg.com/, October 30, 2009.