Competitive Strategies in Wholesale Financial Markets and Proposals to Restructure the U.S. Regulatory System

1
Competitive Strategies in Wholesale Financial
Markets and Proposals to Restructure the U.S.
Regulatory System

• Presentation to the Institute of International
  Bankers
• Charles Roxburgh

2
Three topics

• Scenarios for future of global capital markets
• Competitive strategies in response
• Possible directions for regulatory reform

3
2007 was set to be another record year but then
it all went wrong . . .
301
Millions

• Global capital markets revenues

-15
29
17
267
25 (4Q)
244
46(3Q)
209
198 (1H)
2004
2005
2006
Post-write-downs 2007
Sales and trading, ECM, DCM, loan origination
and syndication, and MA revenues Estimates
based on results of ten Global players, which may
over-state total industry growth in first half
given relative out-performance by leading firms,
plus third quarter actual results and mix of
actual and estimated fourth quarter results for
leading firms scaled up to give industry totals
Source McKinsey Global Capital Markets Revenue
Pools Company reports, McKinsey estimates
4
Before looking forward, lets look back . . .
U.S. securities industry financial results End
Q1 1980 value indexed to 100 (quarterly figures)
Q1 2001 Q2 2005 9/11 and TMT
collapse Duration of decline 9 quarters
max. fall 43.0 Time to recovery 19 quarters
Q3 1998 Q3 1999 Emerging markets
crisis Duration of decline 1 quarter max.
fall 15.2 Time to recovery 5 quarters
Q1 1994 Q4 1994 U.S. interest rate
hike Duration of decline 2 quarters max.
fall 15.8 Time to recovery 4 quarters
Q2 1987 Q1 1989 Black Monday Duration of
decline 3 quarters max. fall 33.5 Time to
recovery 8 quarters
2000
2001
2002
2003
2004
2005
2006
2007
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
1981
Extracted from aggregated income statement,
selected balance sheet, and employment data on
the U.S. domestic broker-dealer operations of all
NASD and NYSE member firms doing a public
business derived from their Financial and
Operational Combined Uniform Single (FOCUS)
Report filings
Source SIFMA McKinsey analysis
5
Last September, we defined four possible
scenarios for the future . . .
Description
Bounce Back

• The credit and liquidity crunches turn out to be
  a short-term blip
• 2007 H2 is tough but 2007 remains a record year,
  revenue growth reverts to long term trend from Q1
  2008 onwards

Steady Recovery

• Some players keep struggling in credit in the
  remaining of 2007, but no major downturn in
  economy
• After identifying all effects and losses due to
  the current turmoil, capital market revenues
  growth picks up in 2008H2

The Long Chill

• Weakened consumers confidence due to the US
  housing market downturn leads to a mild dip of
  economy in early 2008 slight up-tick in default
  rates hits credit markets
• Further interest rate cut in mid-2008 rescues
  markets, but it takes one year for growth revival

Late Tackle

• Liquidity support by central banks and continued
  consumer confidence maintain markets stability
  and growth until around mid-2008
• Inflationary pressures accelerate given loose
  monetary policy. Fed reverses policy and
  triggers 2-3 quarters of recession from mid to
  end 2008

Source McKinsey
6
. . . which we have now narrowed down to two main
scenarios
46
Millions
Total CIB revenues
Steady Recovery

• Benign "soft landing" and quick economic recovery
  in 2008
• Deal pipelines temporarily dry out creating 3-4
  quarters of negative growth in credit, but
  recover in H2 2008
• Europe and Emerging markets remain strong

6
2005
06
07
08
09
2010
The Long Chill

• Early, mild recession in 2008
• Structural change in credit markets
• Continued growth in selected asset classes
• Strong growth ex-US

-1
267
2005
06
07
08
09
2010
Note 2007, 2008, 2009 results include
estimated write-downs write backs
Source McKinsey Global Capital Markets Revenue
Pools McKinsey estimate
7
What will be the next shoe to drop?

• Monolines?
• Commercial Real Estate?
• Leveraged Loans?
• Sub-prime Round 2?
• Litigation?
• Regulatory over-reaction?

Source McKinsey
8
There are common trends across all scenarios
Regional balance

• Emerging markets likely to outgrow developed
  markets
• Western Europe likely to extend lead over North
  America in terms to total capital markets
  revenues
• North America lags behind

Product trends

• Commodities and Equity Derivatives with strong
  prospects under all scenarios
• FX, Rates Cash Equities as winners in "lighter
  crisis" scenarios and still relatively resilient
  in steeper crisis
• Permanent loss of some revenue pools (esp.
  structured credit)
• Continued attractiveness of annuity-like
  transactional products

Source McKinsey
9
Global revenue pools are likely to shift away
from the US
40
Estimated revenue mix by region Percent
100
4
5
Japan
Non-Japan Asia
Other emerging markets
North America
Western Europe
2005
2010 possible scenario
Source McKinsey Corporate and Investment Banking
Practice Industry Scenarios
10
Three topics

• Scenarios for future of global capital markets
• Competitive strategies in response
• Possible directions for regulatory reform

11
Three priorities for maximizing value through a
potential downturn

• Reconfirm recommit to long term strategy
• Continue investment throughout the cycle in
  strategic priorities
• Build emerging markets franchises
• Undertake 'no regret' reviews of risk process,
  capital allocation and non-compensation costs

• Remain committed to clients and talent
• Deepen client relationships, forged through
  adversity
• Re-structure compensation to reward commitment of
  top talent and strengthen link to long term value
  creation
• Maintain active recruiting strategy at all levels
• Reinforce meritocracy

• Invest in the next waves of innovation
• Drive product innovation, e.g., insurance
  securitization, carbon trading,
• Capture convergence opportunities e.g., with
  asset management
• Improve RD and streamline new product
  development processes
• Innovate business and operational models for
  productivity and efficiency

12
Three topics

• Scenarios for future of global capital markets
• Competitive strategies in response
• Possible directions for regulatory reform

13
In 2006 there was growing pessimism about the
prospects for New York City as a financial center
relative to London
153
Do you believe this city will become more or less
attractive over the next 3 years?
Ranking by response Percent
54
15
44
38
8
41
New York City
London
Source McKinsey Financial Services CEO Survey
14
Regulation was an area of particular concern
Ranking by responsePercent
U.S. is much better
2
3
5
2
2
1
U.S. is somewhat better
23
16
13
13
13
14
About the same
45
31
42
45
43
33
26
U.K. is somewhat better
31
32
32
35
34
U.K. is much better
4
7
8
12
14
19
Rules InspireInvestorConfidence
Clarity of Rules
Fairnessof Rules
Uniformityof RegulatoryEnforcement
Simplicity ofRegulatorySystem
Cost of OngoingCompliance
Source McKinsey Financial Services CEO Survey
15
Several reports helped created a consensus on the
diagnosis.
Source McKinsey
16
. . . and a consensus is emerging on some issues
. . .
ü
Supports
Drafting
Bloomberg-Schumer
CCMR
Chamber
Roundtable
Treasury
?
Principles-based regulations
ü
ü
ü
ü
?
Better regulatory coordination
ü
ü
ü
ü
?
Prudential supervision
ü
ü
ü
ü
?
Securities litigation reform
ü
ü
ü
ü
Accounting reforms/IFRS
ü
ü
ü
ü
ü
SOX reforms
ü
ü
ü
ü
ü
Source McKinsey
17
. . . and a consensus is emerging on some issues
. . .
ü
Supports
Drafting
Bloomberg-Schumer
CCMR
Chamber
Roundtable
Treasury
ü
?
New modernized charters
National Commission to study further
Regulatory structure rationalization/
consolidation
ü
National Commission to study further
?
Immigration reforms for skilled talent, business
travellers
ü
?
Source McKinsey
18
U.S. now faces a clear choice bold reforms

• Clarify financial market objectives
• Move to principles-based and prudential
  regulation
• Enhance regulatory coordination
• Reform securities litigation
• Modernize charters
• Streamline and consolidate agencies
• Continue accounting and auditing reforms
• Improve immigration policies to ensure needed
  skills

Source McKinsey
19
U.S. now faces a clear choice bold reforms . .
. or just muddle through

• No clear national objectives
• Continue rules-based regulation with emphasis on
  enforcement
• Rely on ad hoc, reactive coordination among
  agencies
• Keep litigious legal environment
• Leave charters unchanged
• Maintain current complexity and overlap at
  national and state level
• No further accounting or auditing reforms
• Leave immigration unchanged

• Clarify financial market objectives
• Move to principles-based regulation prudential
  supervision
• Enhance regulatory coordination
• Reform securities litigation
• Modernize charters
• Streamline and consolidate agencies
• Continue accounting and auditing reforms
• Improve immigration policies to ensure needed
  skills

Source McKinsey
20
Some predictions . . .

• Current market environment will dominate
  Congressional and regulatory debates in near
  term, understandably postponing needed reforms
  even where there may be growing consensus
• More evidence of eroding US competitiveness could
  drive some consensus reforms this year as a
  regulatory stimulus response before the 2008
  elections e.g.
• Principles-based regulation and national
  standards
• Better regulatory coordination
• ..but need to avoid risk of regulatory
  over-reaction to current issues
• Longer-term reforms new charters, streamlined
  and consolidated agencies, securities litigation
  reforms, immigration reforms will likely await
  new Administration and new Congress in 2009-2010
  and beyond.

Source McKinsey
21
Competitive Strategies in Wholesale Financial
Markets and Proposals to Restructure the U.S.
Regulatory System
charles_roxburgh_at_mckinsey.com

• Presentation to the Institute of International
  Bankers