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The brutal reality is the Central Bankers understand the levers they pull no longer function as they once did. The stark reality is Central Banks have no answer to inflation except to hope and carry on. They are caught between the Scylla of inflation and the Charybdis of a market collapse. This is why so many analysts are confident the markets will win out and keep going higher because central banks have little choice but to keep up the stimulus.

Most of the market is fixated on what the S&P does, what new high the NASDAQ will make this month, or where Amazon is going to top this quarter. They have the vision of a blind man when it comes to anything much beyond the end of their one-year time horizon. Even the bond market seems blind. The market is so focused on the short-term and ignoring the consequences of the last 10 years of QE, monetary experimentation and easy rates, that it's blundering into the next crisis. Inflation matters, and it has jumped from financial assets into the real economy.

The reality is investment should be about the long term. If you ignore the future in favour of short-term gains, it makes it very easy to dismiss the evidence that inflation is actually a very real issue.

Lots of smart non-financial assets funds do understand that and see just how horribly distorted markets have become. That’s why they are so keen to diversify out of corrupted financial assets and into real assets, the hot part of the market.

Going back to inflation, the outlook is complex. For instance, it’s possible to argue the rise in commodity prices is a factor of hoarding. Manufacturers anticipating a surge are preparing for massive post-pandemic demand. The spikes in commodities from copper to lumber are now in reverse. This supports the market’s contention the inflation number is something of an overshoot.

Oil is an outlier. OPEC is a monopoly price setter but it is going through yet another of its periodic organisational crisis resulting in a spike that’s proving difficult to hedge. Owning oil is not a pleasant outcome for anyone as we saw last year when traders found themselves owning negative priced oil when storage was unavailable.

If you ignore the future in favour of short-term gains, it makes it very easy to dismiss the evidence that inflation is actually a very real issue.

There are some of the important underlying trends in the economy like used cars, where prices are rising. It hints that it is details of specific inflation factors in each price that are important. We’re all aware of the global shortage of chips enabling carmakers to cut production and create scarcity, pushing up new car prices, dragging second-hand values higher as consumers seek alternatives. On the other hand, new car prices have been rising for years, with higher costs “justified” by the increasing amount of tech junk put into them. As the EU announces it will outlaw new internal combustion engine vehicles by 2040, I wonder if we are going to see a new countertrend develop. To explain, consider the Land Rover. A 10-year-old low milage, full-service history, Range Rover in immaculate condition may be worth £16,000. A 20-year battered Defender with zero documents is worth £32,000. But you can fix it with Gaffa Tape, WD40 and a hammer.

However, inflation complacency may be the least of Central Bank worries. You may have spotted an increasing number of breathless articles from around the globe on House Price Inflation.

Everywhere on the planet the affluent classes - those with savings, who’ve done well from lockdown, and already on the property ladder – have been driving an uptick in property. It's debt-fuelled and an illiquid market. No one sells till they see what they want to buy, and the ladder is actually a pyramid, with fewer assets on each successively higher rung.

The result is record home prices nearly everywhere. This week US Fed Chair, Jerome Powell and US Treasury Sec Janet Yellen are going to chat about it at the Financial Stability Oversight Council. A body was set up in 2010 to identify excessive risks to the US Financial System after the financial crisis. About time. Housing is frothier than 2007 according to the Case-Shiller US property value index.

Rightly, Janet and Jerome are concerned a second housing bubble bursting could shake the foundations of finance again. However, this time will be different. The housing market is not vulnerable to a massive number of low-credit-score mortgagees defaulting, but to a large number of affluent middle classes suddenly finding themselves financially stretched, on a rung of the ladder they can’t afford, and sitting on negative equity when the bubble bursts.

In the UK, we live with negative equity. In the US, you walk away. Whatever, these consumers consume less.

The structure of the market has also changed. Banks don’t lend anymore. They broke their risks off to the investment sector. In the case of US mortgages, the risk is pushed back to the government through the Mortgage-Backed Bond buyback schemes, and to the non-bank financial institutions that now finance, originate and service mortgages.

This is going to be the really big problem of the next stage of the Global Financial Crisis. Smart money has been loading up on real assets on the basis they are decorrelated from the increasingly corrupted financial asset sector, but the reality is real assets from property, private equity, secured lending, aircraft, shipping, you-name-it, is now getting just as frothy as a result of all that inflation tied up in financial assets now spilling into the real economy.

Financial Asset Inflation has infected the real economy.

With the 10th anniversary of the Lehman Brothers’ shocking and unprecedented bankruptcy this month, Katina Hristova looks back at the impact the collapse has had and the things that have changed over the last decade.

Saturday 15 September 2018 marked ten years since the US investment bank Lehman Brothers collapsed, sending shockwaves across the financial world, prompting a fall in the Dow Jones and FTSE 100 of 4% and sending global markets into meltdown. It still ranks as the largest bankruptcy in US history. Economists compare the stock market crash to the dotcom bubble and the shock of Black Friday 1987. The fall of Lehman Brothers was a pivotal moment in the global financial crisis that followed. And even though it’s been an entire decade since that dark day when it looked like the whole financial system was at risk, the aftershocks of the financial crisis of 2008 are still rumbling ten years later - economic activity in most of the 24 countries that ended up falling victim to banking crises has still not returned to trend. The 10th anniversary of the Wall Street titan’s collapse provides us with an opportunity to summarise the response to the crisis over the past decade and delve into what has changed and what still needs to.

As we all remember, Lehman Brothers’ fall triggered a broader run on the financial system, leading to a systematic crisis. A study from the Federal Reserve Bank of San Francisco has estimated that the average American will lose $70,000 in lifetime income due to the crisis. Christine Lagarde writes on the IMF blog that to this day, governments continue to ‘feel the pinch’, as public debt in advanced economies has risen by more than 30 percentage points of GDP – ‘partly due to economic weakness, partly due to efforts to stimulate the economy, and partly due to bailing out failing banks’.

Afraid of the increase in systemic risk, policymakers responded to the crisis through quantitative easing and lowering interest rates. On the one hand, quantitative easing’s impact has seen an increase in asset prices, which has ultimately resulted in the continuation of the old adage, the rich get richer and the poor get poorer. The result of Lehman’s shocking failure was the establishment of a pattern of bailouts for the wealthy propped up by austerity for the masses, leading to socio-economic upheavals on a scale not seen for decades. As Ghulam Sorwar, Professor in Finance at the University of Salford Business School points out, growth has been modest and salaries have not kept with inflation, so put simply, despite almost full employment, the majority of us, the ordinary people, are worse off ten years after the fall of Lehman Brothers.

Lowering interest rates on loans on the other hand meant that borrowing money became cheaper for both individuals and nations, with Argentina and Turkey’s struggles being the brightest examples of this move’s consequences. Turkey’s Lira has recently collapsed by almost 50%, which has resulted in currency outflow and a number of cancelled projects, whilst Argentina keeps returning for more and more loans from IMF.

Discussing the things that we still struggle with, Christine Lagarde continues: “Too many banks, especially in Europe, remain weak. Bank capital should probably go up further. 'Too-big-to-fail' remains a problem as banks grow in size and complexity. There has still not been enough progress on how to resolve failing banks, especially across borders. A lot of the murkier activities are moving toward the shadow banking sector. On top of this, continued financial innovation—including from high frequency trading and FinTech—adds to financial stability challenges. In addition, and perhaps most worryingly of all, policymakers are facing substantial pressure from industry to roll back post-crisis regulations.”

The Keynesian renaissance following that fateful September day, often credited for stabilising a fractured global economy on its knees, appears to have slowly ebbed away leaving a financial system that remains vulnerable: an entrenched battalion shoring up its position, waiting for the same directional waves of attack from a dormant enemy, all the while ignoring the movements on its flanks.

If you look more closely, the regulations that politicians and regulators have been working on since the crash are missing one important lesson that Lehman Brothers’ fall and the financial crisis should have taught us. Coming up with 50,000 new regulations to strengthen the financial services market and make banks safer is great, however, it seems  that policymakers are still too consumed by the previous crash that they’re not doing anything to prepare for softening the blow of a potential new one. They have been spending a lot of time dealing with higher bank capital requirements instead of looking into protecting the financial services sector from the failure of an individual bank. Banks and businesses will always fail – this is how capitalism works and no one knows if there’ll come a time when we’ll manage to resolve this. Thus, we need to ensure that when another bank collapses, we’ll be more prepared for it. As Mark Littlewood, Director General of the Institute of Economic Affairs, suggests: “policymakers need to be putting in place a regulatory environment that means that when these inevitable bank failures occur, they can fail safely”.

In the future, we may witness the bankruptcy of another major financial institution, we may even witness another financial crisis – perhaps in a different form. However, we need to take as much as we can from Lehman Brothers’ collapse and not limit our actions to coming up with tens of thousands of new regulations targeted at the same problem. We shouldn’t allow for a single bank’s failure to lead us into another global crisis ever again.

 

 

 

 

The year 2017 has been eventful in terms of the various socio-political and economic developments across the world.  Here is Mihir Kapadia’s quick summary of the year as it was.

 

The Year of Elections

After 2016 gave us Brexit and Trump, political and economic analysts across the developed world were wary about the possibility of protectionism spreading across the European continent, especially as 2017 was due series of elections in the region. With The Netherlands, France and Germany, the three big powerhouses of the European Union, going to the polls, there was a real threat of right-wing populist parties gaining prominence and altering the mainstream and liberal values of the western developed economies. The fear was legitimate, as EU sceptics appeared to be inspired by Brexit and Trump and were engaging on similar campaign promises based on nationalism and the closing of borders.

The year delivered relief across the continent, as liberal political parties emerged victorious over right-wing populists; however, the political dynamics and discourse in the region were considerably altered. Eurosceptics including Geert Wilders in The Netherlands, Marine Le Pen in France, and the Alternative for Germany (AfD) party gained mainstream prominence and considerable representation in their respective countries.

Germany is currently in a difficult spot, as none of the parties secured a working majority, Angela Merkel’s CDU has been attempting to negotiate a ‘grand coalition’, in an attempt to break the current political deadlock after coalition talks with the pro-business Free Democrats (FDP) and Greens collapsed. While brokering a grand coalition across parties in the parliament can deliver governance, it is too early to comment how strong the Chancellor’s leadership and authority would be.

 

Trumping the Stock Markets

 While protectionism and populist policy proposals have been part of the 'Make America Great Again' campaign slogans, the larger driver behind the 'Trumponomics' rally has been the hope that President Trump can push through policies to stimulate growth and increase corporate profits. Anticipation of infrastructure expenditures, healthcare reforms and tax cutting legislation helped rally the stock markets to a series of all-time highs. While the stock market has consistently risen strongly since November 2016, despite the fact that many of Trump’s key promises such as infrastructure spending and healthcare reforms are yet to materialise, there are increasing fears that the US stocks are being overvalued. However, these concerns have been there since 2003 when the current long equity rally began.

Meanwhile, the dollar has had a rough year, having lost about 9-10% in 2017, but Trump has probably been happy to see it fall, as it will help boost US exports.

Financial analysts observing the uptrend in the US stock market over the year have cautioned that the markets may already be overpriced. The last time the US economy had a meltdown, it was 2008 and it affected the whole world. The 2008 financial crash occurred because of fragility in the banking system due to poor mortgage lending. The US is currently trending positively on earnings, employment, wage growth, housing and GDP. These indicate no signs of an impending recession; and the Federal Reserve is likely to raise interest rates through 2017 and into 2018. Trump has been indirectly very good for the economy.

 

Dull year for Gold

 The significant threat globally throughout 2017 has been North Korea's aggressive stance against the US and its regional allies - South Korea and Japan. The year-long nuclear ballistic tests and provocative missile launches rattled Asian markets, but net impact was negligible and equities have risen in Asia and elsewhere. Therefore, safe-haven assets, such as Gold, received little support due to these threats.

Globally, the bullish stock market, rising interest rates and a sense of market security proved to be bad news for Gold, US-denominated assets such as Gold are influenced by the movements of the dollar, and its fortunes are also tied to the dollar among other factors. The US dollar has fallen nearly 10% year-to-date (or YTD) in 2017.

Under a bullish Federal Reserve, the commodity had already priced in the factor of interest rate hikes. Only if the actual rate of increase is lesser than expected, gold prices may benefit and see some relief going into 2018. Investors therefore will keenly observe the Fed’s tone when they discuss the interest rates for next year to understand how they would progress into 2018.

 

Brexit uncertainty remains

 Brexit continues to dominate the UK’s political and economic spheres and the year began with the invoking of Article 50 by Prime Minister Theresa May on 29th March 2017. Political discussion around Brexit also led the country into a snap general election in June, resulting in the Conservative Party losing their majority, and further splitting the British parliament.

Since the Brexit referendum of 2016, the pound lost 10% against the Euro and 17% against the Dollar. The fall in the value of the pound in fact worked in favour for the stock markets, with the FTSE100 (which largely comprises of exporting organisations) having reached record highs through the year. While the fall in the value of the currency may have helped British exports, the benefit stops there. Rising inflation and weak wage growth in the UK have directly affected the average British household as the period of uncertainty continues.

While Brexit is inevitable, the financial sector, which considers London to be its capital, is keen on retaining its ‘passporting rights’ - the right for a firm registered in the European Economic Area (EEA) to do business in any other EEA state without needing further authorization in each country. In fact, London has been the major focal point for this very reason – an English language capital city, ideally located between the Americas and Asia and acting as the gateway into Europe. Therefore, any indication of a ‘Hard Brexit’ – one which threatens to pull the UK out of the EU without any deal, is of a major concern for the City of London. The pound and the economy therefore are directly affected over this concern as businesses continue to operate over the period of uncertainty.  The UK also faces an upward of £40 Billion Brexit ‘divorce bill’ payable to the EU, which adds another financial liability to the process.

 

Eurozone recovery at its finest   

 The European Central Bank’s (ECB) president Mario Draghi has expressed the bank’s confidence over the region’s recovery, noting that the momentum has been robust, as GDP has risen for 18 straight quarters. The central bank attributed the overall success this year to improved employment figures in the single bloc, while noting that inflation cannot be self-sustained at this juncture. Mr Draghi used these comments to express interest and possibility for extending the timeline of the slowdown of its bond-buying program, which is slated to start from January 2018.

While the recovery has been robust, the ECB also recognises that it is vital for member states to continue a stable political and economic structure within, and reinforce each of their fiscal structures in order by focusing on both, keeping a buffer rainy-day fund while also working towards reducing debt. While these are words of wisdom for the future, Mr Draghi would also be thankful for the past year as Eurozone mitigated the rise of far right into leadership, especially in France, Netherlands and Germany – the three key powerhouses in the EU. The economy therefore was well protected this year.

 

10 Years of the Financial Crash

 2017 also marked the 10 years of the great financial crisis of 2008 in October, which had sent the risk assets across global stock markets and economies tumbling. The ten years since the financial crisis of 2007-08 has passed quickly and on a better note than anyone could have expected at that point of time. From the collapse of Lehman brothers in 2008 to the arrests of Irish bankers in 2016, the 2008 depression had brought in a wider understanding of the fragile western economic ecosystems. The crash was a serious wake-up call for governments across the world, thus paving way for bringing in regulatory responses to the banking practices - such as the expansion of government regulation, scrutinised lending practices, and tougher stress tests to make sure they can withstand severe downturns.

The financial crash of 2008 provided a learning opportunity to set things right, and our economic mechanisms today have certainly implemented checks and balances to be more cautious in their functionality. If the crash has taught us anything, it is that complacency can be catastrophic.

 

It has certainly been an interesting year, and 2018 holds more opportunities for us than ever before to learn and grow.

Although the exact start date of the financial crash will differ depending on who you talk to, August 2017 was widely acknowledged as the 10-year anniversary of the first signs of the global financial crisis. In the two years that followed, 2008 and 2009 saw the shockwaves of the crash hit the M&A industry, with global M&A volumes falling over 40%, and reported deal values by nearly 55%.

The results of the crash changed the market significantly. Companies now implement increased geographical diversification and investment strategies in secondary markets. In the UK alone, Chinese investment has tripled and US activity has grown 40% since 2014.

Ten years on from the crash, volumes are 5% higher than the 2008 peak, disclosed aggregate values are 12% higher, and the proportion of transactions with undisclosed values is higher than ever, at nearly 60%*. So what happened to the M&A market over the last decade?

Looking back: global transaction volumes

 In the year to the 31st July 2008, overall global transaction volumes fell 7.5% to 9,425 global reported deals. In the following year, they fell another 37%, to a trough of only 60% of their 2008 level (5,962 deals) as companies and investors chose to hold tight and wait out the storm. The drop resulted from lower deal values in sinking equity markets, access to financing for larger transactions and general uncertainty on the economic outlook.

The effects hit some regions harder than others in 2009. The DAX region (Germany, Austria, Switzerland) saw a 24% fall, The Iberian Peninsula (Spain and Portugal) dropped dramatically by 34% and the Nordic region was hit harder, with an abrupt 7% decline in 2008 and a further 39% decline in 2009, pushing transaction volumes 43% below their peak.  The Indochinese market followed a similar pattern with a gentler decline, with volumes growing 1.6% in 2008 (from 368 to 374), then falling by a further 22.5% in 2009.

The UK and North America, the traditional engines of transaction volume, which together accounted for around 75% of deals in 2008, saw the fastest declines. UK volumes fell 7.5% and US volumes by nearly 9%. In 2009, it was the UK market which saw the most severe contraction, as volumes fell by half, pushing transaction numbers down to 817 from 1,762 in 2007. This decline in volumes over the two-year period was significantly greater than the decline anywhere else.

Region    

Transaction Volume – twelve months to 31 July 2007

Transaction Volume – twelve months to 31 July 2009

Two-year Decline in Transaction Volume

Indochina

368         

290

-21%

DAX

1057

748

-29%

Iberian Peninsula

497

336

-32%

Nordics

695

394

-43%

North America       

5,791

3,379

-42%

UK

1,762

817

-54%

Total

10,170

5,962

-41%

 

The peak and the trough: Disclosed values  

Disclosed values tell a more nuanced story. The headlines looked worse, with a decline in global disclosed value of 55%. This makes sense, because smaller deals are less likely to have valuations disclosed. This is usually due to private shareholders not wanting the financial terms to be disclosed and no regulatory pressure to disclose deals below a certain threshold.

This varied by region far more than the slowdown in volumes did. For example, the US had the most abrupt decline in 2008 (down 48%) and a gentler decline in 2009 (down a further 17%, for an overall 57% reduction in reported transaction values). In contrast, the DAX region actually increased deal values in 2008, albeit by less than 1%, then saw a 44% slowdown in 2009.

The UK’s decline mirrored the DAX, but more starkly, with values declining by less than 1% in 2008 then dropping 52% in 2009. The Nordics suffered even more in value terms, as reported aggregate values dropped by nearly a quarter (24%) in 2008 and a further 72% in 2009, closing nearly 80% down on the peak.

Region    

Aggregate reported Transaction Value £m – twelve months to 31 July 2007

Aggregate reported Transaction Value £m– twelve months to 31 July 2009

Two-year Movement in aggregate reported Transaction Value £m

Indochina

25,666

27,136

+6%

DAX

120,686

67,890

-44%

Iberian Peninsula

94,693

42,358

-55%

Nordics

64,879

13,737

-79%

North America       

1,147,136

492,864

-57%

UK

237,711

113,041

-52%

Total

1,690,771

757,023

-55%

 

In the year to 2007, the UK and North America accounted for 82% of global reported transaction value; in the year to 2009, despite their precipitous declines, they still accounted for 80% of global reported value.

Overall, aggregate reported deal values fell faster than transaction volumes, as larger deals which tend to be higher-risk were cancelled or delayed and, wherever possible, sellers sought to avoid disclosing the terms of transactions which may well have been concluded at lower valuations than they would have been 12 or 18 months earlier.

 

10 years on: a market snapshot

Ten years after these significant declines in volume and reported value, what does the landscape look like?

The North American market has increased volumes 80% from the 2009 trough, to 6,067 deals in the 12 months to 31 July 2017, while reported transaction value has surged at more than double that rate, increasing 170% from 2009 to 2017 and is now 16% above the 2007 peak. The business services and media and technology sectors remain key to US growth, together accounting for half of all inbound acquisitions, with the world’s best-developed funding environment for start-up and high-growth companies.

The DAX region shows a similar profile, with transaction volumes up 58% and values nearly doubling to 130% of their 2009 level. The Iberian Peninsula has shown gentler growth and remains below its 2007 peak. With volumes increasing 40% from 2009 to 2017, aggregate values remain 30% down on their 2007 levels while volumes. However, as the Spanish economy turns a corner, Chinese interest in the market rose markedly this year.

Indochinese volumes are up the most compared to 2007, now at 30% above their peak, while values have nearly tripled - with aggregate reported transaction values topping £100bn compared to £26bn in 2007. Transaction flow between China and Europe is expected to grow even stronger.

The Nordic region has shown the greatest growth, as volumes more than doubled from 2009 to 2017 and are now 24% above their 2007 peak, while aggregate valuations more than tripled from £14bn to £55bn, although this is still 15% down on the 2007 peak of £65bn. Chinese interest remains important in this market and American acquisitions increased quickly in the second half of 2016.

Volumes in the UK market have nearly doubled from 2009 to 2017, but remain 8% down on their 2007 peak, while reported values grew 61% from 2009 and remain 23% down.

Region    

Growth in Volume 2009-2017

Growth in reported value 2009-2017

2017 aggregate reported value relative to 2007 peak

Indochina

66%

274%

+294%

DAX

56%

130%

+29%

Iberian Peninsula

40%

49%

-33%

Nordics

118%

302%

-15%

North America       

80%

170%

+16%

UK

98%

61%

-23%

Total

79%

150%

12%

 

 To infinity and beyond

 Despite the effects of the crash still reverberating through the political sphere, the market as a whole has shown itself remarkably sanguine about what would previously have been considered major macro-political uncertainty. Political change and economic uncertainty in Europe, the unpredictable statements and actions of President Trump, and the self-imposed uncertainty caused by the Brexit vote and subsequent approach to negotiations have all had relatively little effect on the markets.

This remains a strong sellers’ market. The drive for growth from strategic acquirers has seen volumes rise steadily since the trough, and accelerate since 2011, albeit with a few bumps in the road causing short-term and temporary slowdowns.

The wall of private equity money in search of high-quality investment opportunities, combined with the influx of new investors such as debt and pension funds that are willing to make direct private equity-style investments for bond-like yields, have driven values for differentiated, market-leading businesses to compelling levels not seen for over 10 years.

The ready availability of super-cheap debt has helped fuel and finance these valuations. Owners of well-performing businesses considering their exit options may be well-advised to take advantage of these conditions, which have now surpassed the previous highs of the 2007 peak in most markets.

*  Livingstone Global Acquirer report H2 2016 http://livingstonepartners.com/wp-content/uploads/2017/03/Global-Acquirer-Trends.Digital.pdf

D: +44 (0)20 7484 4731  l  M: +44 (0)7903 161330

15 Adam Street, London WC2N 6RJ

http://livingstonepartners.com/uk/

 

By Mihir KapadiaCEO and Founder of Sun Global Investments

 

 

10th anniversary since the financial crash and the things that have changed as a result of the crash

 

The ten years since the financial crisis of 2007-08 has passed quickly and perhaps in a better way than anyone could have expected at that time. As a matter of fact, I remember exactly where I stood trying to be brave in the face of market turbulence, and began to set up a wealth management firm at a time when all the markets and investor confidence was heading down.

I decided to focus on the emerging markets where the underlying economic growth was resilient and where investment opportunities offered a good prospect of promising results.  This was my motivation as I set up Sun Global Investments, a wealth and investment management firm, within six months of the onset of the subprime mortgage crisis. Now, as we have clocked 10 years since the crash, a lot has changed in the world – from an increase in regulations, a long period of low interest rates and easy monetary policy and new competitive threats.

The period of reformation

From the collapse of Lehman brothers in 2008 to the arrests of Irish bankers in 2016, the 2008 Great crisis led to a wider understanding of the fragile western economy ecosystems. The crash was a serious wakeup call for governments across the world, thus paving way for new regulatory responses for banking practices and financial services in general. This period also saw the expansion of the relevant regulatory bodies.  New Capital Adequacy liquidity and leverage norms came into place.  We also saw increased scrutiny of lending   practices and tougher stress tests.  The regulators were strongly motivated to avoid a future banking crisis in which taxpayers would be called on to bail-out failed banking institutions.

Today, we can be reasonably assured the global banking system is much safer due to the increased regulatory effort in the interim period.  The major problem that we faced going into 2007-08 can be summarized under four headings - excessive borrowing, flawed compensation structures, weak regulation, and moral hazard.   The regulators have sought to address all these areas.   Time will tell whether these measures are enough to avoid another crisis and another taxpayer funded bailout.     The long period of low interest rates and easy monetary policy have encouraged huge asset bubbles and higher levels of borrowing – these trends indicate that the limits of the resilience of the global economy is being tested greatly.

 

Testing the limits

In Europe, the banking crisis led to a severe sovereign debt crisis which affected Ireland, Spain, Portugal, Italy and Greece.  After a long period of adjustment, the first three countries have recovered to varying degrees but the latter two still remain greatly constrained by their high debt levels and negative or very low rates of economic growth.  Greece was the worst affected and continues to suffer greatly from the very negative consequences of the economic crisis ten years ago. The problem of high debt levels was compounded by any other problems such as the mismanagement of public funds by the government.   The country plunged into a massive recession as GDP contracted by 25% and the country was forced into seeking an IMF bailout.  The Greek debt crisis continues to weigh on the priorities of the European Union and IMF.   Much of the political and electoral uncertainty of the last two or three years have been a direct result of the prolonged economic slowdown which has followed the global financial crisis.

Looking into next decade

When Barack Obama assumed office, it was on a wave of optimism that he could fix the American economy which was reeling under the depression of 2008.  In the eight years of the Obama Presidency, employment and asset markets grew strongly.  However, income inequality grew over this period and many former industrial areas did not benefit greatly from the increased growth and higher asset prices. Eight years later, the American public responded to the tones of protectionism, the closing of borders and the economic nationalism of the Trump campaign.  In the UK, the referendum decision to leave the EU was a global political earthquake driven by nationalism and populism. The rise in nationalism reflected a population that had grown poorer and disillusioned in the years after the Great Financial Crisis and used the opportunity provided by the Referendum to express their unhappiness.

After the Brexit result and Trump victory, the threat of the advancement of right wing populism had faded in Europe by the end of 2016, with the election results in Netherlands and France. However, the next decade ahead will remain in difficult and uncertain due to the economic and political difficulties which are the lasting legacies of the Global Financial Crisis which started ten years ago.

In the UK, the uncertainty caused by Brexit is being further compounded by rising consumer, corporate and government debt, and increasing inflation which are squeezing living standards.  As the former Chancellor of the UK, Lord Darling recently warned, we are once again seeing sharply rising risks and increasing complacency as the memories of the crisis fades.  It is perhaps particularly grave for the UK as it in the midst of a serious period of Brexit negotiations that could have a negative effect on Businesses and households, and perhaps depress economic growth.

The financial crash of 2008 provided us a learning opportunity to set things right, and our economic and financial mechanisms have been strengthened but many dangers remain particularly the high level of debt which has emerged during a decade of very low interest rates and easy monetary conditions.  If the crash has taught us anything, it is that complacency can be catastrophic.

The Brightside is east

 

It is not all dark in the global economy. The US economy is proving to be resilient and is some way down on the path to monetary policy normalisation. China is also defying the forecasts of a sharp slowdown in its rate of economic growth.  China and other Emerging markets remain a bright spot in the global economies as many of them are growing at 4.5% to 6.5% a year.  Their markets offer promising and stable opportunities for investment. This is a viable and exciting option for global investors seeking to make progress in the 21st century – an alternative to near stagnant or slower growing western economies.   There are likely to be Exciting times ahead!

August 9th marked precisely a decade since the start of the financial crisis. On that date in 2007, BNP Paribas was the first major bank to acknowledge the risk of exposure to the sub-prime mortgage market when it announced that it was terminating activity in three hedge funds that specialised in US mortgage debt. Inevitably, the regulatory progress as a result has evolved and became extremely rigorous.

Looking back, we can attribute the financial crisis in part to model complexity and systemic obfuscation in the derivatives and credit markets. Banks have been placed under a microscope and scrutinised for their resilience to a wide range of risks. This is hardly surprising, given the post-Global Financial Crisis (GFC) realisation of interconnectedness of systemic risk and the financial services industry, particularly for so-called globally Systemically Important Financial Institutions (SIFIs).

To maintain the industry’s public good of wealth creation, liquidity provision and sound money management, financial services must address deficiencies in model governance by learning from practices implemented by “high integrity” aerospace, medical, and automotive industries. While model and data governance have been elevated in regulations such as TRIM, BCBS 239, Solvency II and the PRA Stress Test guidance, regulators and all industry participants on sell- and buy-sides must work harder to drive thorough model governance standards.

Now, the financial services industry is complex and rightly thrives on complexity – that’s how it fosters wealth creation in the real economy. The industry can manage complexity in risk better, but not by patching together systems with additional spreadsheets and tools of often unknown origin. It can work towards a harmonised architecture/platform which manages, models and reports risk whatever the department and job role, whether a chief risk officer, risk modeller, developer or front office representative. It should be able to deal, too, with the uncoordinated barrage from regulators and supervisors.

In software terms, this is achievable. It has been realised in non-financial organisations. Look at the automotive industry: building an automated safety-first model to production process, with validation and verification, has increased vehicle reliability, assurance and environmental protection, as well as unleashing the vehicle design creativity resulting in multiple new features at reduced cost, and significantly improving the driver experience. This process has enabled the development of safety-first assisted or fully-automated driving delivery of capabilities to the market.

Financial services can and should strive to do the same. It is quite possible for risk, projection and valuation models to be built, customised and improved, rapidly, consistently and in coordination. It is also possible to implement while minimising technical debt, applying good development processes that in turn foster continuous system improvement. Those models can be made available to whoever needs them, whether ardent researcher, FATCA-liable executive or prospective customer.

However, this requires cultural change. Established bureaucracies need to be at worst crushed, at best, reformed. Cries of “we’ve always done it this way” should be challenged. Financial institutions must seek to reduce complexity where complexity adds nothing, both in communication and in model development.

That said, we are seeing an increase in the development of new financial models. After the crash, experts highlighted the importance of model review, or as some presenters termed it, challenger modelling. Regulations are more baked here, with CCAR promoting “benchmark or challenger models”, and SR11-7 favouring “benchmarking”. The Bank of England PRA, has previously pinpointed model review and challenge as processes needing improvement.

Some suggested challenger models could incorporate machine learning, perhaps too black box for current frontline regulatory calculations, but this could prove interesting for validation and potentially improving accuracy.

In comparison to other industries, the financial services industry lacks a certain degree of understanding of software verification – that the software, as opposed to the model, delivers true output. The aerospace industry boasts regulations such as DO178C, which go far beyond anything in the financial services.

But, new financial models have greater predictive capacity and have far superior accuracy overall than previously obtained with linear models. Using an effective mathematical modelling tool, it may be possible to predict another financial crisis before it arrives.

With all this in mind, to succeed in addressing good model governance, financial institutions should aspire to a unified system with reduced operational, model and legal risks, servicing multiple disconnected supervisory regimes, in turn improving productivity through risk-aware development.

A decade on, regulators and banks have tackled the problems of model complexity and systemic obfuscation in the derivatives and credit markets, but the industry now heads into a new bubble of artificial intelligence, even bigger data, crypto-currencies, robo-advisors and a proliferating patchwork of confusing, unsourced and often poorly-supported computer languages, putting the international population at risk of experiencing new global financial and economic crises.

With the wave of new technology, cybersecurity is another factor that must be considered when calculating financial risk. Details of measuring it and bank mitigation are still vague but it’s importance should not overshadow the ongoing problem of human errors, which have the potential to cause an equal amount of damage.

Given that we are still feeling the ramifications of the previous financial crisis, it is imperative that good model governance standards are agreed upon. In this regard, financial risk managers can and should lead the industry in developing sound model governance practices.

 

About Stuart Kozola

 Stuart Kozola is Product Manager Computational Finance and FinTech at MathWorks. He is interested in the adoption of model-led technology in financial services, working with quants, modellers, developers and business stakeholders on understanding and changing their research to production workflows on the buy-side, sell-side, front office, middle office, insurance, and more.

Website: https://uk.mathworks.com/

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