Deep Currents

The credit crunch has left the banking industry reeling, and the Economist takes a shot at capturing how it’s most likely to evolve in this week’s special. It starts by noting the reasons for Wall Street to have hope: emerging markets continue delivering strong revenues, longer lifespans mean increasing investment in pensions, the many new sovereign wealth funds need help finding good returns, and the growing global economy will bring up the industry with it. Besides, financiers are adept at making money in any situation, and don’t forget that banks may be getting back their central role as credit evaluators now that the system of “originate-and-distribute” (a.k.a. “make bad loans and sell them to unwitting investors”) has been discredited. Then the author describes what is likely to change:

• Funding may need to come more from retail customers’ deposits than from other banks since the wholesale market is currently very expensive
• With costlier borrowing for banks, the price of debt for customers will go up: profit margins will be thinner, the least-profitable areas of trading could be cut down (such as proprietary trading at investment banks), and retail banks will place an emphasis on efficiency
• The level of capital on hand considered prudent will be higher, regardless of whether it is required by regulation, which means more selective lending in order to protect profits
• Private equity firms will start buying up banks since prices are low and many could be improved with operational tweaks
• Being large and diversified (e.g. Citigroup) will continue to be a good strategy: they are more resilient, less exposed to anyone country or type of risk, and contain retail deposits that won’t vanish in bad times

Written: May 17th, 2008