The Future Belongs to Smaller Players

By Roy C. Smith

18 years ago when Financial News first appeared, the market capitalization of all the stocks and bonds in the world, according to McKinsey, was about $80 trillion, or two and a half times world GDP, and there was a lot to write about.

The financial world had just entered an exciting, dynamic and optimistic decade, sweet-dreaming of deregulation, global integration of capital and merger markets, transformational new technologies, easy money and, most of all, a new powerful financial vehicle to capitalize on it all – the global universal bank with a big balance sheet and a kick-ass “flow-trading” business model.

By the end of FN’s first decade, global market capitalization had exceeded $200 trillion, almost three and a half times world GDP. 

The dreams had all came true. Big banks repeatedly merged with each other to form the $2 trillion behemoths they are now, they leveraged their equity 30 times, provided all the “liquidity” any client could ever want, bet on markets themselves, paid out big bonuses, and believed it all was because they were so smart.

In FN’s second decade, there was just as much to write about but it was much less pleasant as the financial world experienced and adapted to the great Financial Crisis. Mostly, FN was reporting on the industry’s recurring nightmares of forced deleveraging, re-regulation, write-offs, layoffs and litigation.

In the aftermath of the Crisis, much of what was done in the sweet-dreaming years was undone.

Big balance sheet business models are being dissolved. Dynamic flow trading is just a memory. And much of the profitable business of the global giants has migrated, along with much of their talent, to hedge funds, boutiques, private equity and other locations within the non-systemic “shadow banking “world.

Over the next 18 years, this long unwinding dynamic will have fully played out.  Banks will have a new role model: Wells Fargo, today’s most valuable bank with a market capitalization of $260 billion from a growing and profitable national commercial and retail banking franchise that pays out more than half of its earnings to shareholders. They could make a worse choice.

Still, the banks will keep their hands in the capital markets, they being the principle link between clients and markets. They will lend, underwrite and advise, as they do now, but they will distribute most of what they originate to the countless investing entities of the shadow-banking world, which will become the real source of credit and liquidity.

What will be left of bank trading will be done electronically, with better markets and lower costs.

What will be new will be deeper dive that banks take into finding better ways to securitize mortgages, restructure government debt and organize privatizations in the many places where this is needed, provide finance for trillions of dollars of infrastructure investment, and help pension funds around the world realign their portfolios.

18 years from now, markets could easily be capitalized at $500 trillion. No better alternative to market economics has yet been found, so the markets will continue to grow. But the key players in it, as they always have, will change. Big, systemically important banks will have their role to play, but a universe of smaller, less-regulated, non-systemic, non-banks will be the source of much of the innovation and energy that sustains the markets.

They will coexist and supplement each other, just as they did fifty years ago.

From eFinancial News, May 19, 2014