“Technology innovation in the financial markets (securitization and credit derivatives) allowed for an arbitrage process to gradually develop between financial markets,” Campa explains (See previous newsletter).

That innovation was what allowed the asset risk to be transferred from commercial banks—which were subject to regulation—to investment banks, insurance companies and a number of other unregulated financial intermediaries.

“On top of that, we must also contend with geographic arbitrage. In other words, these assets were also transferred from national institutions with tougher regulations to institutions in countries where regulation is less strict (hedge funds)," says Campa.

The result is $800 billion in reported losses, $963 billion in capital injections aimed at saving the system, and an estimated $500 billion for additional financing needs in the future. As Campa explains, “the problem is not only the sums that have already been furnished, but those still to come."

If we couple that with the prevailing lack of trust in the markets and general economic pessimism, then the question arises as to who is going to guarantee liquidity from now on. “It is inconceivable that this money could come from private institutions. The experience of investors who in the past few months have furnished capital to troubled institutions—only to find themselves relegated to the background by the governments forced to inject additional capital into the institutions—is a very bad precedent,” states Campa.

For their part, the governments are all aware of this reality and are preparing themselves with measures such as the one recently adopted by Germany, where a legislation was passed allowing the government to participate in private companies.

“Market liquidity is not guaranteed. Financing has become costlier and credit is less available, which has a negative affect on companies and the confidence of families,” states Campa. Moreover, he says, right now companies are being run with the sole mindset of generating enough cash to survive, and are not looking beyond their financial needs for the coming months.

“In this environment, the lack of projects has a debilitating effect on the granting of bank credit, expansion and economic growth in the future. And it has a similar affect on borrowers' ability to pay back their existing loans,” he adds.

Campa also reiterates the assertion that, “[it is] absurd to think that this vicious circle of deterioration in terms of activity and confidence is not going to affect the solvency of companies and families that are currently in debt." Driving home the point, he says that, “this will also have a direct effect on banks. The reduced quality of their assets diminishes the capitalization of banks and savings institutions. As a result, some will be unable to cover their liabilities."

The looming bank restructuring will not be a minor one. This is the opinion of the International Monetary Fund after studying over 120 banking crises that have taken place in the past 35 years.

Campa alludes to history by stating that, “on average, more than 30% of the banks existing before a crisis like this end up disappearing one way or another. About a thousand banks disappeared due to the American crisis of the 1980s; in the Asian crisis of the 1990s, over 40% of the banks in Indonesia and South Korea went under; in Russia, 30% shut down following the country's crisis of 1998."

According to the finance professor, “we will be seeing a process of concentration taking place in the industry. Some banks will be liquidated, others sold, by way of mergers or through the more or less organized sale of their assets to other financial institutions." The fact is that this process is inevitable in any sector facing a crisis of such magnitude. But how will this restructuring take place?

Juan José Toribio says that the process will occur at two levels. “First, we have seen the integration and transformation of investment banking moving toward a more traditional model. Second, we will witness the aforementioned sectorial restructuring process.”

With regard to the first level, Javier Aguirreamalloa calls attention to the downturn currently affecting the investment banking sector. “Right now the investment banking pie is the same size as it was in 2004. The difference is that back then the market was growing and now it's headed in the opposite direction. We are seeing lower revenues, lower earnings, staff cuts...and this trend will continue over the next two years,” he commented. According to Toribio, the main problem facing investment banking is the shortage of recurring revenue, which has led to a major dependence on individual transactions.

The President of the CIIF alluded to how, as a result of the current crisis and the problems it has caused, investment banking is shifting toward commercial banking. “The banks that have not disappeared have either been acquired by commercial banks or transformed themselves by offering an expanded range of services resembling those of traditional banking,” explains Toribio. In his opinion, this integration or transformation toward commercial banking “offers adequate financing via deposits and greater maneuverability in times of recession, as we are in now, where the plug is simply pulled on many normal operations."

Nevertheless, there are some threats. Pablo Fernández points out the risk of mixing these two types of business, while Aguirreamalloa adds that, “they are two different activities, each having its own distinct company culture and salary models, which could ultimately cause numerous problems when it comes time to integrate the two."

One way or another, as Toribio concludes, “we should expect to see a period of banking activity that focuses on the 'commercial' aspect. The events of these past few months and the new regulations to come will force that to happen."

Javier Aguirreamalloa examines what, up until now, were the most lucrative businesses in investment banking and discusses products trends for the coming years.

“Corporate mergers and acquisitions will be greatly affected for at least the next two years. To acquire a business, the most important thing is confidence and visibility in the transaction, and right now few companies can offer that. Liquidity is another must, and banks are not presently furnishing that capital,” explains Aguirreamalloa.

“Likewise, the two other major businesses of investment banking—equity and fixed income—are on the decline. There is no need to harp on the collapse of the stock markets. The same can more or less be said for corporate bonds and securitizations. Both markets have simply dried up."

From the product standpoint, if the market volume has gone down, then investment banking customers—investment funds, hedge funds, private-equity funds, etc.—have also been reduced or disappeared. “Hedge funds have failed to generate absolute returns as promised," he adds. “Meanwhile, they have been unable to meet their investors' required return. Finally, they have had to endure a number of scandals caused by fraudulent managers that have damaged the reputation of these businesses. Consequently, many of these investment vehicles have disappeared,” says Aguirreamalloa.

With respect to private equity, the finance expert foresees serious difficulties lying ahead. “Since 2004, these funds have purchased companies at exorbitant prices, reaching inordinately high debt ratios in the process. As a result, we will see private equity funds going under, as we've seen with hedge funds."

Nevertheless, Aguirreamalloa argues that, as a business concept, private equity seems to have a brighter future than investment in listed securities. “This crisis has shown us many things, one being that there are no free lunches in the stock markets. If you are seeing major returns, you are probably running major risks as well. Conversely, by buying unlisted companies, private-equity investors are playing in less efficient, less liquid markets, and thus a good manager is in fact able to consistently generate value.”

Aguirreamalloa also leaves room for hope: “Along with these negative structural changes, there are also some positive aspects. Families' tendency toward saving has a more detrimental effect on consumption and as a result investors will once again need to channel those savings toward financial investments."
With respect to corporate debt, Aguirreamalloa acknowledges that, “currently the deleveraging of companies implies reduced balance sheets. That means shelving some otherwise viable projects. However, there is still a need for investment, financing and refinancing, and someone will have to cover that need. This will not be the end of investment banking."

According to Aguirreamalloa, simplification will be the trend in the coming years. “We are headed toward simpler products across the board in the financial markets. The trend is to put simplification before innovation. There will be a push for products that are less sophisticated and easier to comprehend." The financial crisis has apparently reminded buyers that they should understand what they are investing in and what the risk is.

In any case, Fernández says emphatically that, “asset securitizations should continue, since they are processes that allow for risk to be distributed and can benefit many investors and financial institutions." He adds that it was poor management that caused the crisis, and not the vehicle itself. “Saying that securitizations are responsible for the crisis is like blaming the car for a fatal accident in which the driver was going 250 km per hour."

The current imbroglio with the international financial system coupled with the investment banking fiasco will give rise to numerous corporate transactions that will restructure the banking system in the coming months.

“The sector needs to be consolidated. The limited growth of credit in the future will leave little room for the existing institutions,” says Campa. However, when it comes to the restructuring process, the 'how' will be more important than the 'who.'

“Neither mergers and acquisitions nor consolidations can solve the underlying problem by themselves. The restructuring will be the result of problems mainly involving solvency and it is unrealistic to think that a relatively healthy institution would take over one that is in trouble simply for the good of the system,” explains Campa. He adds that, “one must not forget that along with corporate transactions, when they occur, there will need to be an injection of capital and/or a freeing up of the assets of those troubled institutions."

According to the professor of IESE's Department of Economics and Finance, this should be a three-part process: “The direct intervention of the troubled institution, temporary management of said institution to separate the good assets from the bad, and the subsequent sale of the good assets to other operators." Although this process will likely occur in one fell swoop with a transaction involving the injection of public capital in order to offset the toxic assets.

Toribio agrees, calling attention to the same two major threats as Campa. First, the liquidity problems that, as mentioned before, are being addressed by capital injections from the central banks and asset acquisition programs carried out by governments. Then come the solvency problems, for which two mechanisms have been put in place: nationalization, as seen in England, and the creation of a "bad bank" to help eradicate the toxicity from the institutions.

Despite all the difficulties, the banking industry is starting to discern the paths it should follow in the future. To the dismay of many, all of them entail new regulation.

Campa gives a clear answer to this question: “more regulation should not be the recipe for a more stable environment. What's needed is better regulation so as to reduce the chance of having more arbitrage like the cases we have been seeing. Meanwhile, an evaluation is needed as to the proper use of the innovations appearing in the financial system, especially when they entail possible effects on third parties."

One certainty is that the last attempt to increase regulation in the financial system produced some results that were results contrary to the stated objectives. “The Basel II standards established a minimum level of shareholder equity according to the troubled assets of each financial institution. This minimum was decided by consensus of the countries involved, however no study was done on the real needs of the institutions. The standards contained loopholes for the processes of securitization that were carried out by banks and which ultimately depleted the level of the institutions' own resources per troubled asset...precisely what the regulation was designed to avoid," points out Toribio.

The President of the CIIF calls for “the supervisory organizations to start paying more attention to systematic risk. Whereas Basel II placed emphasis on the risk of each institution, now there is a need to implement regulations to additionally establish “protective” mechanisms for the entire system."

Campa, also argues that regulation should be reoriented, so that the regulator has jurisdiction over the size of the market. “This is a basic principle that is commonly accepted in our environment. It is what happens, for instance, in the realm of antitrust. Nevertheless, markets as internationalized and interrelated as the financial markets still use systems largely based on national regulators that focus on specific institutions,” explains Campa. Thus he is adamant in calling for a change: “regulation by national institutions should be coordinated in order to avoid arbitrage, whether geographic or between competing products."

Aguirreamalloa agrees with taking this direction, adding that, “in addition to making the regulation more transnational or cross-border, it should be aimed more at the products than the institutions."

One way or another, all agree that, at the end of the day, the fundamental requirement for the survival and recovery of the banking system is for the international financial systems to be governed by common sense, prudence, transparency and traditional banking values. That will be the only way to restore sustainability to a system that is still reeling from its latest crisis.