What lessons can be drawn from the global financial crisis nearly five years after the fall of Lehman Brothers? That was the topic debated by a panel of top financial executives from Asia at the recent Wharton Global Forum in Tokyo. The discussion, led by Wharton finance professor Franklin Allen, explored potential lessons, as well as the potential risks, still lurking in the global financial system. Some members of the panel felt that sufficient steps are being taking under Basel III reforms, and internally at banks, to forestall a new financial crisis anytime soon. They even suggested that some reforms may have gone too far. But others were far less sanguine, expressing concern that banks — and the overall financial system — have not reformed sufficiently to avert a new crisis, and that big risks remain at the macro level (the European debt situation, for example).
As a private equity (PE) practitioner “working in the trenches,” Richard Folsom, representative partner for Advantage Partners, said the first lesson he would point to is the fact that companies have managed to emerge — even from a once-in-a century financial crisis — with profitability intact. “We’ve never had a rising tide or tail-winds the entire time we’ve been investing,” Folsom noted. Despite that, Advantage Partners found that with sound governance and properly aligned incentives among investors and stakeholders, firms can significantly outperform their peers.
The second lesson: When sound underwriting and due diligence are neglected, financial crises ensue. “The lesson is that informed investors or underwriters can make money in any market, including recessionary environments, and will have much smaller loss ratios in times of crisis,” Folsom said. At the same time, it is vital to focus on improving operations rather than just tinkering with financial engineering, and ensuring that the interests of shareholders, management and employees are aligned. “Properly aligned incentives can lead to a significant competitive advantage,” Folsom noted, adding that such initiatives also make a company more efficient and profitable, maximizing value for customers and offering greater rewards to employees.
From the point of view of a consultant working mostly with banks, McKinsey director Keiko Honda said one lingering question is why Japanese banks managed to survive the crisis in relatively good shape. This is all the more puzzling given the very low levels of demand for lending since Japanese hold cash and cash equivalents equal to 5.7 times the average annual capital investment of all Japanese corporations (187 trillion yen), which is roughly 33 trillion yen a year.
The Japanese banks have fared well because they did a good job of managing nonperforming loans and because they had already undergone a major consolidation following the bursting of Japan’s bubble and the Asian financial crisis in the late 1990s, Honda noted. As they consolidated, “Japanese banks did extensive cost cutting.” European financial institutions looking to Japan for advice might want to bear in mind that the number of bankers at the money center institutions was reduced by nearly 40%, while almost a third of branches were eliminated.
Signs of Adjustment
According to Jon Kindred, president and CEO of Morgan Stanley Japan Holdings, the crisis impressed “significant lessons” on financial institutions, policymakers and regulators. The most fundamental is an obvious, but apparently overlooked, truth: “Large financial institutions exist to serve their clients,” Kindred said, rather than just to suit themselves. Industries and regulators need to also fully come to grips with today’s complex levels of interconnectedness. “The failure of one financial institution [Lehman Brothers] sent tremors around the world,” Kindred noted.
The deepening complexity and global nature of the financial world has made products and systems more difficult to understand, Kindred added. By the time the financial crisis hit, derivatives had become opaque, unclear and hard for regulators to analyze. Since derivatives have become a critical tool for financing, the market is now being made more transparent. At the same time, there is a growing recognition of the risks and relationships between leverage and liquidity. Leverage had gotten “way too big,” Kindred said, as banks’ balance sheets ballooned in size. “High leverage and low liquidity of assets is a dangerous brew,” he noted. Much of the debt was confined to financial institutions that have now been reprimanded that their purpose is to serve the real economy, not just to move money around.
Such issues ultimately hinge on the culture and ethics of the financial institutions and the bodies that regulate them. “Overall governance structures need to be changed, and that clearly has been happening,” Kindred said, pointing to the higher capital requirements required under Basel III. “Extra capital, extra standards for governance, accounting standards, money laundering and derivatives, central clearing and margin requirements” — all are part of the effort to clean up the industry and manage for risks. But such moves can also hinder economic activity. Many in the industry worry that the Basel III requirements will have severe negative consequences. “This is an issue of ‘constructive tension’ right now,” Kindred added.
Masanori Mochida, president of Goldman Sachs Japan, was less upbeat in his assessment of the lessons drawn from the crisis, despite a more acute awareness now of the need for better risk management. “As a bubble continues to grow, people tend to become more and more confident and believe, ‘This time is different.’ We’ve seen this again and again.”
What came as a big surprise was the recognition that even firms with low leverage and huge scale can be exposed to huge risks. Goldman Sachs’ conservative approach to risk management involved keeping cash on hand to ensure its capital was adequate even in a “stress environment,” Mochida noted.
Like Mochida, Weijian Shan, CEO and chairman of PE firm PAG Asia, was somewhat skeptical about the financial industry’s propensity for learning from crises. After all, many of the lessons being learned this time around were driven home in Asia during the regional financial crisis of the late 1990s, he stated. “Western banks don’t know any better than their Eastern counterparts,” even though the Asian banks largely derived their own lessons from the West and the International Monetary Fund as they cleaned up their balance sheets and began imposing stronger risk management regimes following the Asian crisis.
For Asia, “the good news is that most of the banks learned from those experiences and shifted from policy and relationship banking to basing lending on creditworthiness,” Shan said. He thinks the Western banks need to relearn the basics of how banking should be conducted.
For the PE industry, one key lesson is that portfolios must be managed for the long term. Overall, the PE market has underperformed the public equity market. “Sometimes PE substantially outperforms, but in a crisis, sometimes it underperforms,” Shan noted. This is partly because PE generally involves more leverage, which tends to distort in both directions. “When your performance is good, it makes it better. When it’s bad, it gets even worse,” Shan said.
Another point that should be taken to heart: Bankers are still overpaid, Shan suggested. Like Folsom, he favors incentives to ensure that bankers’ interests are aligned with those of the companies they are handling. “Bankers with large holdings of stocks are less likely to push companies to take on excessive risk,” Shan noted.
Allen raised the issue of compensation and performance in the question-and-answer session. Kindred said Morgan Stanley has sought to reinforce a positive realignment between long-term performance and compensation in its own pay packages. “At Morgan Stanley, we paid no cash bonuses. Every bit of compensation was deferred, a big chunk [of it] in stock. The industry has already moved or migrated in that direction, and the cultural norm is changing in a positive way.” Aligning client investments with bankers’ own self-interests can help encourage good investment decisions, Folsom added.
Following up on Shan’s description of the cleanup that occurred after the Asian financial crisis, Allen questioned why Japan’s fundamental economic performance has been so dismal, despite the relatively strong condition of its financial institutions this time around. “Why did Japan do so badly? Even before the tsunami, it was way below where it was before the crisis,” Allen stated. Mochida’s explanation was that while Japanese financial institutions have been very cautious and maintain huge deposit bases, Japanese companies are extremely global. “So they were very badly hit,” he said.
Compounding the problem was the surge in the value of the Japanese yen against the U.S. dollar and other currencies. “The yen appreciated so much against the dollar, and that hit Japanese companies really hard,” Honda noted. Combine very global companies with a high exchange rate and plunging exports, and the results are obviously going to be dramatic.
A Growing Disconnect
At the same time, though, there seems to be a growing disconnect between financial markets and the real economy, Allen stated. “Financial markets have been booming, but in the real economy, growth trends are very tepid in most of the world,” he said. “Are we going through another session of boom and bubble in the stock market, and is it likely to burst?”
In Japan, Folsom noted, the key to restoring growth in the real economy will be structural reforms, or the so-called “third arrow” of Prime Minister Shinzo Abe’s economic plans. “The market is watching Abenomics very closely,” he said. It is “popping a lot of money into the economy; that money has to go somewhere.” The same applies in the U.S.
Kindred said his discussions with Japanese leadership suggest that they have a strong will to push ahead with reforms, and are well aware that if they don’t, any market gains will be reversed. “Only recently, Japanese retail investors have changed to being net buyers” in the share markets, Kindred noted. “There is potential for a quick reversal if there is no tangible progress on the third arrow.”
For now, everyone is waiting for Japan’s election for the upper house of parliament, which could give Abe’s Liberal Democratic Party a strong mandate for pursuing its reform agenda. Since this is Abe’s second term in office, following his one-year stint in 2006-2007, he is well prepared with regard to what he wants to do and how to get supporters aligned behind him, said Folsom. “Once the upper house election is over, things will happen in a different way.”
Progress should not be taken for granted, though, said Kindred, in response to a question from the audience. Most Japanese companies are small- and medium-size enterprises. But the big multinationals at the top of the pyramid exert powerful political influence. “Japan Inc. is a formidable force, and there will be a considerable struggle,” Kindred noted. He also expects Japan’s likely participation in the Trans-Pacific Partnership regional trade arrangement to be another locomotive for change. “Don’t underestimate it. It’s mainly about regulatory and structural normalization,” he added. “Changes will have to be made that will make it easier for business here.”
The Asian financial crisis drove home the crucial nature of structural reforms, noted Shan. That fiasco resulted mainly from structural deficiencies and problems in the economy. But while its own bubble burst years earlier, in the early 1990s, Japan did not go through that sort of fundamental restructuring. “By and large, the corporate structure remained intact. Cross-shareholding remains,” Shan said. The easy access to low-cost capital has conversely enabled the corporate sector to endure very slow growth. “Yes, there is some movement in Japan. But to sustain any recovery, it really depends on this ‘third arrow’ of structural reforms.”
Turning to broader horizons, participants once again remarked on the risks posed by the restrictive Basel III requirements. Equity is costly because there is a perception of substantial risk in the banking sector. “Yes, there needs to be more regulation. Yes, capital needs to be enhanced, but you have to do it in a way that is manageable,” Allen said, noting that if capital requirements are too high, the industry may never attain those standards.
Shan characterized the capital requirements as “politically motivated, not economically motivated.” What is fundamentally more important is knowing your customers and having good risk management, he said. “No matter how much capital you have, if you manage it badly, you can fail,” Shan noted. “If you do maintain a good quality of capital, then 5% of capital is enough.”
Given these views, what is most likely to spur another crisis? The European debt imbroglio? China’s murky debt situation? Folsom pointed to rising levels of leverage. Honda noted the massive “excess liquidity” being created by central banks as they print their way out of recessions. Shan contended that a potential military confrontation in Asia could be the most likely scenario, though he puts the odds of that at “30%.”
Apart from preventing that, it is crucial to ensure that markets are adequately regulated so that there are enough “checks and balances,” Shan said. “Depending on ethics is not going to be enough.”
The massive quantitative easing prevailing at the time suggests that governments are not adequately addressing the risks of a future financial crisis, noted Kindred, who views sovereign risks as a “massive boil-over” likely to explode. “At some point, it has to be addressed on the political level. There have to be structural reforms so that the debt can come down.”