Our risk transformed future
Hugh Wheelan finds out about an array of potential investment products
Investment banks and financial institutions could see their profitability slashed in half over the next decade by new attitudes towards risk management and risk allocation, according to a report published the International Securities Market Association.
The report, entitled: ‘The Risk Revolution and its Impact on Securities Markets’ presents results of a survey carried out amongst ISMA member firms suggesting that growing competition in international capital markets will cut margins by 50% or more in the next five to ten years.
And the news gets no better for investment banks and asset management firms.
Report author Andrew Freeman, European business correspondent with the Economist magazine, goes on to argue that enhanced financial engineering skills coupled with irreversible inroads made by insurers into financial market territory will have the potential to create a serious challenge to the traditional role of investment banks.
Asked which industry trends are having the most significant impact on business today, 73% of ISMA members place increased use of technology at the top, followed by the effects of globalisation with 66.7% of votes. Increased customer sophistication comes in sixth at 35%.
However, pushed to predict trends over the next five to 10 years, ISMA members believe customer sophistication will rise sharply as an issue - almost doubling to 67.5%, just behind technology.
Freeman says an obvious implication here is that customers will increasingly be able to do things by themselves, noting the impact this will have on margins.
From data compiled on the US securities industry, he points out that average margins for firms managing institutional securities fell from 110 basis points (bps) to around 62bps between 1985 and 1997.
Consequently, the survey shows three quarters of respondents predicting margins of at least half their present level in 10 years(assuming current levels of 100bps), with one-fifth seeing the collapse going down to around 20bps.
“The realisation is that the globalisation and disintermediation will have a severe impact on business,” says Freeman.
Furthermore, questioned on how many securities exchanges will be around in 10 year’s time (assuming a figure of 200 in existence today), over three quarters predict less than half that number, with 35% forecasting a drop to between 20 and 50.
More than half believe electronic only exchanges will be the trading systems of future winners, while electronic access for institutional clients is predicted to double in importance from 43.1% to 85.4%.
The upshot of this technical revolution and squeeze on fees, according to Freeman, will be a radical transformation of the securities market.
In what he terms the “risk revolution”, Freeman predicts a move towards the unbundling of common equity risk and the availability of bespoke risk packages to investors.
‘Old fashioned’ equity, he believes, will be replaced by purer risk/reward specific contracts and a proliferation of new instruments.
“Instead of single bundled equity, a firm might issue an array of different securities from which investors could select those most suited to their risk attitude,” says Freeman. The advent of increasing numbers of electronic crossing networks (ECNs), he adds, will serve as the exchanges for such transactions.
“Previously, it was felt too high a hurdle to slice and package equity risk, but now we are on the cusp of having the intellectual approach and technology to create these structured bundles and the exchanges are about to appear that will enable trading of these packages.”
Freeman argues such a structure could provide a lifeline to brokers being squeezed out of the traditional exchange system.
“I believe that here is an opportunity whereby brokers and intermediaries could be the vehicle for bringing in packages of risk to suit investors and tailoring it to their exposures and structures.
“Firms that can innovate here will be able to take advantage. Some are already doing so.
“The more a risk can be made specific, the more likely it is to be accurately priced and, consequently, the greater the chance that it will be acquired by an end investor.”
Financial engineering skills, he adds, now mean different tranches of risk such as property fluctuation, short-term trading, economic, legal and reputational risks can be calibrated with impressive precision.
Such techniques will enable companies to de-couple interesting proprietary risk from problematic generic risk, so allowing engagement in more high-return activities, he argues.
Using the example of an oil company, he says risk could be divided across exploration, production and short term oil prices to give portfolios of risk activities. The result of stripping away these risk elements from equity assets is the creation of completely different equity streams, Freeman says. Equally, this could apply to corporate bonds: “On the credit side you could strip off bonds to represent different risk factors such as the failure to gain business contracts, which could operate like insurance contracts.”
The revolution, Freeman says will be the creation of an environment with networked electronic markets where millions of consumers can become more sophisticated in their financial affairs.
“The new risk bearing contracts will make possible a depth of liquidity previously unknown in financial history,” he points out.
However, Freeman acknowledges the argument is not without hinderance, noting that the issue of who holds the equity in a company will be important. “Other difficulties will arise with regulatory bodies and there are agency problems over issues of asymmetric information, which is still something we have to challenge,” he comments.
Notably though, Freeman refers back to the ISMA survey to highlight an issue where he believes members may not be seeing the whole picture.
Asked who might profit from changes in the corporate appetite for risk management. Some 65% of ISMA members believe investment banks will reap the rewards, with 22.8% plumping for asset managers and only 11.4% selecting insurers.
However, Freeman argues that corporate CFO’s are increasingly seeing a link between financial risk management and insurance.
As an example, he highlights the renaissance enjoyed by British Aerospace after shedding its leasing risks by persuading an insurance consortium to cover the underlying financial risk. This, he says, changed market perception of the company and saw the share price rise 15% in a matter of weeks.
He also notes the greater role being played by insurers in risk management, pointing to the development of products incorporating elements of earnings protection already offered by insurer Reliance National and being developed by AIG.
The potential exists, he argues, for insurers to develop guarantee products on the number of seats sold by an airline – a short step towards guaranteed earnings contracts.
Despite the criticism, Freeman says there are already examples of careful implementation of such contracts on top of existing insurance plans, thus avoiding the issue of an insurance companies earnings being transferred to shareholders of the insured.
“Advancing from here the potential exists for a proliferation of catastrophe products to emerge along the lines of weather derivatives for shipping companies,” he comments.
Looking further forward Freeman also envisages the possible creation of macro markets where national-income risks could be hedged against certain regions or even the entire world.
“I accept there is a futuristic sense to this vision, but I believe the financial arguments are quite strong in its favour,“ Freeman opines. “Securities firms that successfully pursue the opportunities presented by current technologies will go about as far as is possible towards having a chance of existing by the end of the 21st century.
“There is precious little room for complacency in today’s financial industry.”