“What keeps you awake at night?” In interviews with more than 1,000 C-level executives at firms around the globe – including 54 financial institutions – IBM researchers trotted out that standard question. Quite a number of deep issues, it turns out.
“A very high number of financial services executives, 80%, is figuring out what their future business model should look like, regardless of how they have fared throughout the crisis,” said Suzanne Duncan, a financial markets analyst for IBM’s Institute for Business Value. “An event like this, which is once in a century, has everyone shaken up and thinking through their identity.” The other 20% are focusing on the short term – keeping off the front page, shoring up balance sheets and figuring out how to get credit.
For the IBM team, it has been a busy time. Focusing on just the US for the last three weeks they have seen a decade’s worth of industry consolidation, creating a barbell effect with big firms on one end, very few mid-size firms in the middle and lots of small firms on the other end.
“Regulators are looking at this and realizing that too-big-to-fail takes on a new meaning when the three largest firms – JP Morgan, Citi and Bank of America – control 35% of the assets in the US. And we are seeing a similar phenomenon in Europe.”
Looking into the future, the IBM researchers expect the financial services industry will break into three segments:

• Alpha seekers: People pursuing risk will break away from the big banks, which under commercial bank licenses will not have the leverage, or the high rewards, that investment banks and investment bankers enjoyed in the past. Companies as different as Citadel and Lazard may expand into more investment banking activities. Joining forces with hedge funds or private equity firms they might, over time, develop into a new bulge bracket firm.
• Beta transactors: Building on the universal banking model to offer retail banking, sales, and agency trading rather than supporting a large proprietary trading desk. Regulators will probably mandate that the vast majority of securities trade electronically with greater transparency. Most securities will move away from OTC transactions. Banks can make more money in OTC when pricing is opaque, but when instruments move to exchanges the volumes typically rise, she adds.
• Advisory services with relatively low risk providing wealth management programs to individuals.
  Regulators will probably impose strong regulation on banks that fall under the Fed’s domain, but they will also probably require greater transparency across the industry, including hedge funds and sovereign wealth funds.
  “They know from Long Term Capital Management that an opaque fund can take the system down. They want to strike the balance between regulation and financial innovation, and they are working with academics to figure it out.”
  IBM researchers believe the next wave of innovation in finance will be around the client in an industry that has focused on developing products.

RISK
Even in the spring of 2007, before the financial crisis began, only 5% of firms in finance said they were comfortable with their risk management capabilities, said Duncan. Now they are feeling even more nervous.
It’s a vital issue because the industry is growing interconnected at a rapid pace – country to country and firm to firm integration is increasing at 9.5% compound annual growth.
“We anticipate shocks to come more frequently and be much larger because of the effects of integration,” she added. When you take the mere 5% who are comfortable with their risk management, she expects firms to move away from relying on traditional tools such as the bell curve, portfolio theory and value at risk (VaR). The industry will require a new world of theory built around holistic risk that spans market, credit and operational risk.
Investment banking suffered from herd behavior. Executives knew of the risk their firms were taking, but as Citi’s Chuck Prince so memorably phrased it, they decided to keep dancing as long as the music was playing. Wall Street leaders were under pressure from Wall Street, quarterly expectations, and analysts. It takes strength to head in the other direction, said Duncan.
In a previous study, IBM looked at two companies which chose not to continue down the road of risky subprime investing – Goldman Sachs and GE. Their approaches were similar, she said. Depending on the market, senior executives would meet weekly or daily with a variety of people in the room – traders, the head of risk, the CTO, the chief executive and others and have a really painful, data-intensive conversation. They would present scenarios that were qualitative and quantitative – what’s the worst that could happen with subprime, what would our clients, competitors and regulators do, what would we do?
“People who were part of these meetings say they were not easy, but they were driven by intellectual curiosity and stimulation to get to the bottom. They were backed by a lot of data and by cultural openness.”
Although many banks appear to have a poor record on, their corporate clients are looking to them for advice on the subject.
“Despite the fact that bankers are deep in the weeds with their own risk management, their clients are still looking to them for guidance and advice,” said Duncan, drawing on data from early October. “The nonfinancial firms realize no one is perfect and they lean on the financial services firms for advice. They are interacting with their firms more often because they are so uncertain.”
She sees several themes unfolding in the future.

• Overcoming scale squander: Firms haven’t been as efficient as they could have been. Now there will be a real focus on efficiency, especially during consolidation. Academics say the days of 30 percent returns are over; the future will see about half that level.
• Focus on clients: In the IBM survey, clients and financial firms are disconnected an astounding 75 percent of the time. The primary focus at financial firms is to offer one-stop shopping. Customers don’t want it – they want superb execution. Make my life easy, they plead. One-stop shopping was dead last on their lists. They want specialization for better performance.
• Continued consolidation: Consolidation really happens only after a crisis. In good times, the industry is content with over capacity. Bank of America and UBS have both announced they will specialise within their universal banking model, says Duncan. Like GE, they will manage a portfolio of businesses which are responsible for their own risk and return. This has the potential of eventually leading to spinoffs, especially where there are culture clashes, as have been seen before between commercial bankers and investment bankers.

Among the successful firms, a very few had good risk management in place. Most of the survivors had little appetite for risk, like Japanese banks which went through horrible times in the 1990s.
Regulators will have to figure out a governance model – who will regulate what, how they will improve harmonization.
“The top two areas of focus we found were something to do with capital and something to do with transparency, but those terms are so big they could move in lots of different directions.”

Filed under: regulation, risk, Securities & Capital Markets, Technology