10 things that changed in 10 years that had nothing to do with Lehman
Imagining capital markets and investment banking in 2018 without the global financial crisis is a big leap. The chaos and turmoil of 2008 deeply scarred traders, bankers and regulators and defined the intellectual imperatives for the changes that followed — the wholesale revamp of prudential and markets regulation, the bailouts, the reorganisations, the new monetary tools and new ways of seeing the world. But the past 10 years haven’t all been about the crisis.
Despite the profound legacy of those events, it would be wrong to imagine that, over the course of a decade, pre-crash capital markets would have continued more or less unaltered. All of the changes in the market have been affected by the experience of 2008, particularly the fall of Lehman — but many would have played out, anyway.
Here are 10 trends shaping the markets of today that would have happened however 2008 had played out.
1. Making less money
However events might have played out in an alternative reality, it’s ridiculous to think investment banks would soon have returned to 2006-07 levels of profitability. There was no more runway to go down, no way of continuing to add leverage and every chance that steam would come out of a hot market — even if, in another life, this could have deflated gently.
Many of the businesses fixed income sales and trading divisions are involved in are commoditised, straightforward operations where ruthless competition ought to compete away much of the margin on offer. Pockets of the market where outsized returns existed in 2006 and 2007 often relied on off-balance sheet leverage, through derivatives, SIVs or creative approaches to risk weights. The natural bid for exotic bespoke derivative structures exists, but it is limited in scope. Expansion in these areas wouldn’t have run forever and, sooner or later, there would surely have been some kind of regulatory reckoning.
2. Paying more attention to profit
By the same token, investment banks, sooner or later, would have needed to stop pushing for universal waterfront growth and started thinking harder about profit, not just revenues. Shareholders were indulgent when the pie was expanding, but some of the pre-crisis business models never made much sense.
In many if not most industries, the top offerings in a given market take an outsized share of wallet and profits. They benefit from network effects, branding and market dominance. Investment banking and capital markets are no different, and the business strategy of spreading across as many markets as possible, accepting second-tier status for the sake of a presence, would always have to end.
It was no secret that listed investment banks were largely run for the benefit of employees, not shareholders, and were hotbeds of empire-building, warring fiefdoms and fragmented, under-invested systems and back offices. Poorly designed incentives encouraged bankers and traders to use banks' capital resources without properly costing them and rewarded piling up revenues without charging costs back to desks. Much of the long grim grind of restructurings in the past five years has been about fixing multi-decade under-investment in systems and risk management — not just about a response to post-crisis regulation and pressure.
The technological backbone of investment banking has been moving forward regardless of the crisis, and would have changed sales and trading businesses in fundamental ways. Increased computing power has enabled growth in high frequency and algorithmic trading, both in absolute terms and in touching more and more asset classes. The pre-2008 buy side may have been more relaxed in paying commissions and spreads, but it was still a competitive market, and executing vanilla trades with high touch salespeople was always going to be inefficient.
The slow march in e-trading platforms in fixed income would have also carried on. It’s received a push, in Europe, from the MiFID II rules — but these, too, were not crisis rules. MiFID I, passed in 2004, was up for review, like all European regulation, after five years. The crisis helped shape the experience and approach of the policymakers that drafted it, but the bond market has been looking towards an e-trading world since the 1990s.
Recent innovations in primary markets technology, such as the adoption of Ipreo’s Investor Access by some firms, and the development of a competitor product in the US, also fit a trend with a much older pedigree. The World Bank was issuing “e-bonds” in 2001, and banks have been fighting to bring electronic efficiency to the primary markets ever since.
4. Market manipulation and surveillance
There’s a line linking the Libor scandal to Lehman. Shrinking unsecured interbank markets meant fewer real transactions; public anger at bankers helped encourage crusading regulators and prosecutors to go hard after fraudulent Libor submissions
But Libor had spiked around monthly mortgage resets for years before the crisis, and the basic crime for which traders were investigated and banks fined was fraud, as demonstrated in countless ugly chatroom logs. Manipulation in FX markets and the ISDAFix, too, would surely have seen the light of day eventually. The pre-2007 world wasn’t some Wild West where regulators and prosecutors waved through financial misbehaviour — it may have been more wild than post-crisis, but the sort of geniuses that called their FX manipulation chatroom ‘The Cartel’ wouldn’t have stayed hidden forever.
Libor and the other manipulation scandals had consequences — in fines, in regulation, in market structure — that are sometimes lumped in with the broader crisis regulation. But these changes were coming for the fixed income market, anyway.
Reaching for the rulebook now comes easier to politicians and markets authorities, but this behaviour would have been stamped on regardless. There was never a time, Lehman or no Lehman, when the public had much sympathy for traders such as Christian Bittar, who once received a $126m bonus at Deutsche Bank, and pled guilty to Libor rigging earlier this year.
5. Rogue traders and surveillance
Just as important in the growth of surveillance in investment banks were three of the largest ever rogue trader scandals — Jérôme Kerveil, at Société Générale in 2008, Kweku Aboboli at UBS in 2011, and Bruno Iksil, the ‘London Whale’ at JP Morgan in 2012.
None managed to bring down their institutions, like Nick Leeson at Barings more than a decade earlier, but Lehman or no Lehman, these losses all cost their banks serious cash — more than enough to convince management teams that oversight of the trading floor could be strengthened. Rogue trader losses don’t just cost cash up front — they sit on a bank’s balance sheet for up to a decade in the form of extra operational risk capital.
Now-familiar forms of monitoring, including tracking of emails, Bloomberg chat, and scraping company phone audio for keywords, would have ramped up in the past decade, as increasingly sophisticated AI tools ease the burden of combing through communication. Investment bank employees are more careful than ever before about what they’ll put in electronic form, while some are turning to the likes of WhatsApp and Telegram to bypass bank-authorised channels. Banks in turn have upped their game, banning personal mobiles on trading floors and installing more physical monitoring infrastructure.
6. Buy side consolidation and passive investment
One of the biggest changes in the structure of the capital markets has been the consolidation of the buy side, with the top firms taking an ever larger share of total global AUM.
Some of the consolidation has come from active M&A, such as Pioneer’s merger with Amundi, but plenty has been driven simply by asset-gathering at the largest firms, particularly in passive indexing strategies.
Admittedly, some of this came once iShares, the ETF market leader, came out from under the wing of Barclays and into BlackRock in 2009, but the trend was clear and present before the crisis.
Whatever the capabilities and regulations around investment banks, ETFs and other passive strategies fit a clear market need — low cost execution and exposure. Post-crisis regulation has helped ETFs displace CDS in some areas, but, crisis aside, end-investors have always looked for value from their money managers.
Big buy-side operations have also diversified across different asset classes and into different shapes. Sovereign wealth funds and asset managers now behave like private equity firms, which behave like real estate managers, which behave like credit funds. Hedge funds have brokers on the side; PE firms have capital markets desks.
Some of this you can put down to banks pulling back, writing fewer long dated loans and committing less balance sheet, under pressure from post-crisis regulation. But that denies the agency of these highly dynamic buy-side institutions. There are real, non-regulatory reasons why pension funds and sovereign wealth might be better sources of patient capital than bank treasuries, and why being the biggest client on the Street has advantages.
7. Money laundering and KYC
One of the biggest headaches for banks in the last 10 years has been the growth in “bureaucracy” associated with ‘know-your-client’ and ‘anti-money laundering’ provisions. These affect investment banking, impeding leveraged loan settlements and CLO warehousing, for example, but add cost right across the industry, from retail to wealth management to trade finance and corporate lending.
But this headache springs from decisions that have little to do with the crisis — mainly the US’s increased willingness to use its control of the dollar-based financial system to implement its foreign policy.
This is good in some respects — it’s very hard to defend funding a genocidal regime in Sudan, as BNP Paribas did with some of the transactions it was fined $8.9bn for facilitating in 2014. But it has, for example, made it virtually impossible for European countries to cling to the Iran nuclear deal against the opposition of the Trump administration.
It has also been fuelled by leaks such as the Panama Papers and increased focus on offshore finance. If you squint hard enough, you can trace a line back to the crisis, through increased inequality and public anger — but the drive to uncover offshore funds, identify tax evasion and punish rogue states goes back much further.
Outsourcing the investigation of money laundering to banks, enforced by hefty fines, is a political choice by governments, with little to do with Lehman, prudential regulation or the financial crisis. But it has had a huge impact on banking.
8. Climate finance
Fixing the climate by cutting carbon emissions has been an urgent moral imperative for decades, and the finance industry has been, until recently, very slow to react. Otherwise respectable institutions such as Société Générale and Barclays continue to finance climate-wrecking projects like the Rio Grande LNG terminal and the Dakota Access Pipeline.
But the growth in climate finance over the past 10 years has been extraordinary. The first supranational climate bonds emerged in 2007 and 2008, but the green bond market has grown to more than $100bn, while climate finance more broadly defined has leapt up the agenda. More and more asset managers are offering ESG funds, and engaging more and more with portfolio companies on environmental issues.
Even asset managers that don’t want to engage have been forced to confront environmental risks — the $65bn bill for BP’s Deepwater Horizon disaster in 2010, the costs to Volkswagen of rigging emissions tests or the spectre of a mounting bill associated with Monsanto’s weedkiller RoundUp have a way of focusing the mind.
It’s impossible to ignore the presence of climate opportunities, and climate risks in today’s capital markets — and it’s nothing to do with the financial crisis. Yes, banks needed some good news to sell after becoming pariahs but a generational shift was already under way, driven by rising sea levels, a hotter planet and oceans increasingly full of plastic gunk.
9. Distributed ledgers
Cryptocurrencies could be the payment systems and capital raising tool of the future, or they could be a bubble filled with scam artists — or more likely, a little of both. They’ve raised relatively little institutional capital for established companies so far, but they’re certainly a brand new way to source funds and something enabled by mathematics, technology and relentless innovation from the technology sector.
Broader distributed ledger technology wasn’t even a twinkle in the eye of chief technology officers 10 years ago and, while the race to adoption has recently seemed to slow, in several sectors it could revolutionise settlement, trust between counterparties, and toughen the plumbing that sits behind markets.
10. More bonds
For every wistful reminiscence about the pre-crisis Global ABS parties or the free-flowing, freewheeling fixed income days of yore, it’s worth remembering that the bond markets today are bigger, better, and more highly functioning than ever before.
Yes, there are real worries about bond market liquidity (and post-crisis regulation), but the deal sizes achievable since the crisis have vastly increased. More companies are active in the bond markets than ever before, raising bigger deals more competitively. The bond markets have funded some of the largest ever acquisitions in the past five years, boosting bank confidence in their M&A lending takeouts and raising the bar on what’s achievable.
This, too, is surely a secular trend, separate from the post-crisis regulatory reforms. Bank balance sheets have become more constrained, true, but the institutional, real money bond markets were always the natural home for big investment grade companies to raise debt for the long term. Since the crisis, but not because of it, they’ve truly come into their own.