The Global Financial Services Industry in transition

1. The Global Financial Services Industry in transition By: A V Vedpuriswar July 27, 2009

2. Views of an expert Interview with Lord Turner, Chairman UK Financial Services Authority. Source: Financial Times

3. The Global meltdown : The events of September 2008 Day in September Event 7 Fannie Mae, Freddie Mac nationalised 14 Bank of America acquires Merrill 15 Collapse of Lehman Brothers 16 Collapse of Reserve Primary, AIG bailout Goldman, Morgan become bank holding companies 22 25 Washington Mutual placed in receivership

4. Where are we headed? The worst recessions in the US Long deflation : 1873 –1879 Great Depression : 1929 – 1933 Severe recession : 1973 - 1975 Severe recession :1981 - 1982

5. Growth outlook for 2009 • The crisis began in early 2007. • World output may shrink by 0.5 – 1%. • US GDP may fall by 2.6%. • Euro GDP may fall by 3.2%. • Japanese GDP may fall by 5.8%.

6. Medium Term Unemployment Outlook

7. Philosophical views of the crisis(1) • “The more risk we take because we believe the environment is low risk in character, the less the environment continues to be low risk in character.” - Peter Bernstein • “You cannot measure something and observe its movements at the same time because the act of measurement changes the character of motion.” -WenerHeisenberg Interest rates remained too low for too long. Between 2000 and mid 2008, the worldwide notional value of derivatives went up from $ 95 trillion to $ 684 trillion.

8. Philosophical views of the crisis(2) • “Every state nurtures forces that lead to its own destruction.” - Hyman Minsky • “Stability inevitably leads to instability.” - Hyman Minsky • “Instability leads inevitably to stability.” - Peter Bernstein

9. Understanding Banking • What is special about banking? • Why is it such a regulated industry? • Channelise savings into productive investments. • Transform short term debt into long term loans. • Manage the risks involved. • Fragility • Government support • Regulation

10. The Strategic importance of Banking The Economist July 11, 2009

11. Banking and the Sub Prime Crisis Globalization, Macroeconomic imbalances Liberalisation & deregulation Financial innovation Asset bubble Huge household borrowing 11

12. The sub prime crisis at a glance Rise in home prices Buyers priced out New affordable products Home sales rise Buyers can now afford 12

13. The housing bubble

14. The importance of US residential real estate (2007) 14

15. Central Banking and Sub Prime :Federal Funds Rate movement (2000-2008)

16. Low inflation and interest rates- Explaining the Conundrum In 2005 more than 800 million people of the world’s labour force were engaged in export oriented activities. An increase of 500 million since the fall of the Berlin wall in 1989. What were the implications? This reduced world wages, inflation, inflation expectations and interest rates. Emerging markets also ran big trade surpluses. What were the implications? Excess potential savings flooded global financial markets driving real interest rates lower. 16

17. The importance of emerging markets

18. Globalization of capital Source: The Economist dt Oct 9, 2008

19. Rise of the Sovereign Wealth Funds Top ten stake acquisitions in financial institutions, 2007 19

20. Financial innovation and the World of Derivatives

21. The Intoxicating world of Credit default swaps

22. Derivatives and the Real Economy ( 2008 Q2) 22

23. Long Term Outlook for US Government Finances

24. The looming debt crisis in developed countries

25. Government debt, % GDP across Western nations *Forecast; † Difference between forecast primary budget balance in 2014 and primary balance needed for debt sustainability as calculated by the IMF.

26. The future of the Dollar

27. Long Term Inflation outlook • What does the rise in implied volatility in recent months mean ? • Ten-year Treasury bond yields have fluctuated between just over 2% and almost 4% since December. • Many countries are experiencing mild deflation. • But investors are worried about fiscal deficits and quantitative easing

28. Fortune Global 500 Banks - Shrinking Revenues (1)

29. Fortune Global 500 Banks - Shrinking Revenues(2)

30. Fortune Global 500 Banks - Shrinking Revenues(3)

31. Mindboggling Losses

32. Banking industry market cap 32

33. Global Banking : Average leverage ratios in 2008 12:1 USA 24:1 Britain 28:1 France 28:1 Denmark 29:1 Switzerland 52:1 Germany 100 years back, the leverage ratio was 4:1. In the 1970s, it was 10 – 12 : 1. In 2006 it was Morgan- 33, Goldman-26, Merrill-32, Bear -34 Source: Niall Ferguson, “The decent of finance,” HBR, Jul-Aug 2009.

34. Regulatory implications • Basle I • Basle II • Leverage ratio (Total assets / capital) • Regulation of liquidity • Macro prudential approach • New restrictions on derivatives / OTC trades • Controlling the shadow banking system • Revival of Glass Steagal Act?

35. From asset management to liability management • Quantity of capital • Duration & sources of funding • Lengthen the maturity of deposits • Dependence on more stable deposits

36. Tier 1 capital • Tier 1 only includes best-quality capital. • Absorbs losses, firm can continue as a going concern. • Is the core measure of a bank's financial strength.

37. Tier 2 capital • Includes mainly subordinated bonds. • Serves as capital buffer only in a case of bankruptcy.

38. Total assets of leading banks – 1Q09 2'500 2'000 1'500 (USD bn) 1'000 500 0 BoA JPM Citi DB UBS CS GS MS adj.¹ adj.¹ Trading portfolio assets & PRVs Collateral trading Net loans All other assets Source: As reported by companies. Converted into USD, CHF at 1.14 and EUR at 1.32 at the end of Mar 09 1 UBS adjusted reflects PRVs based on Swiss GAAP netting (USD 153bn on 31 Mar 2009). DB adjusted represents US GAAP estimates as reported by company. 38

39. Net loans and allowances for loan losses – 1Q09 1'200 1'000 29 800 28 32 600 (USD bn) 948 400 3 681 626 4 2 200 360 302 209 70 31 0 BoA JPM Citi DB UBS CS GS MS Net loans Allowance for loan losses Source: As reported by companies. Converted into USD, CHF at 1.14 and EUR at 1.32 at the end of Mar 09 39

40. Risk weighted assets – end of 2008 1'321 1'259 1'148 1'015 996 70 68 632 95 430 957 400 893 33 283 279 241 177 493 26 37 80 346 216 184 176 152 BoA JPM HSBC RBS Citi Barc DB GS UBS MS CS USD bn Credit risk Market risk Operational risk Total RWA (Basel I) Source: As reported by companies. Converted into USD, CHF at 1.07, EUR at 1.39 and GBP at 1.46 at the end of Dec 08 BoA, JPM and C did not disclose RWA by category (not a requirement under Basel I). At the end of 2008, MS and GS were regulated by the SEC as Consolidated Supervised Entities and disclosed capital ratios accordingly. Beginning in 1Q09, they report capital ratios in accordance with the capital adequacy standards for bank holding companies (Basel I) 40

41. Capital base Tier 1 ratios – 1Q09 Basel I Basel II Source: Companies reporting. Updated on 15 May 2009 1 11.0% represents pro-forma Tier 1 ratio, taking into account the effects of the announced sale of UBS Pactual2 Beginning in 1Q09, MS and GS report Tier 1 ratio in accordance with the capital adequacy standards for bank holding companies 41

42. The emerging paradigm in Investment banking • Shift to less risky but profitable businesses. • And which need less capital • Advisory services • Providing trading platform • Custody business • Less proprietary trading

43. Global Merger Trends • The value of global mergers and acquisitions (M&A) fell by 35% in the first half of 2009 to $1,140 billion. • The number of deals collapsed by more than 15% in the three months to June. • Buy-outs by private-equity firms have fallen sharply by 82% to $24 billion in the six months to June. • Finance remains the centre of action , accounting for almost a fifth of deals by value, followed by health care and mining.

44. Towards Risk adjusted compensation

45. Emerging trends in Global Wealth Management • HNI lost $10 trillion (quarter of their wealth) during the crisis. • Global number of billionaires fell to 793 from 1125. • Clients highly dissatisfied with service. • Heightened client concerns because of Bernard Madoff. • Clients’ sense of financial security undermined by crisis.

46. Diminishing Trust • Move into “alternative” assets backfired for many clients. • Correlation increased, few diversification benefits. • Performance criteria for wealth managers vague. • Trust is critically important. • But trust is low today.

47. Future Outlook (Offshore banking) • There are doubts about the long term future of bank secrecy laws. • Off shore wealth is estimated at $5 - $7 trillion. • OECD has identified 40 tax havens. • 49 agreements have been signed to exchange tax information since 2000. • UBS had to pay a fine of $780 million and disclose the names of 250 customers. • Germans have targeted bank accounts in Liechtenstein. • Swiss competitive advantage is under threat.

48. Future Outlook (Banking Business Models) • Standalone investment banks? • Pure retail banks? • Universal banks?

49. Future Outlook (Returns for shareholders) • Less leverage • More capital • Lower fees due to distrust of customers and government intervention • Higher barriers to entry • Overall lower return on equity

50. Conclusion : Revisiting Adam Smith • Markets as a self correcting mechanism • Smith did not advocate sufficiency of market economy • Values & institutions play a key role • Prudence • Humanity • Justice • Generosity • Public spirit • Reach & limits of market economy need to be understood carefully