The Day after Tomorrow Thoughts about the future of the world’s financial system

Relika Mell

Senior Manager

PricewaterhouseCoopers

June 2009

The Day after Tomorrow
Thoughts about the future of the world’s financial system

In the disaster film “The Day After Tomorrow” (2004), the world is hit by unprecedented climatic disasters, New York is flooded in a huge storm and then buried under metres of ice. By the end of the film, the survivors face a rather different world, where the former laws and rules no longer apply and have to be re-established. In such a situation it is naturally understandable that people are asking themselves and each other what exactly happened and why, but from the survival point of view it would be much more important to know what to do next and what the new conditions are going to be like. The same can be said about the global financial and economic crisis that we have been currently hit by: it is important for us to understand its causes and to learn from it, but it is even more important to understand in what direction the world’s financial system is changing and moving forwards and what the new rules of the game will be.

Contrary to previous economic depression or crisis periods in the world, it is very probable this time that money and capital markets and the world economy as a whole are on the brink of serious structural changes, in the course of which various rules and power balances we have so far been used to will cease to apply.

The World is turning east

Although the USA will presumably remain the world’s most important economic power for at least another few decades, the period of US-centred world economy and policy is coming to an end and the world is becoming more multi-polar. Developing economies are increasingly influencing the flow of goods and the industries and markets attractive to new investments according to their own needs. Banking will go with this flow.

Strong banking industry is based on trust, stability and well-established regulation. Many of the financial centres of the so-called Western world boasted these qualities over the years, but now, after having been shaken up by the crisis, they are facing the hard path to restoring trust.

The bursting of the bubble also pointed out macro-economic problems, where things are out of balance and criticism should be directed not only at countries in deficit, but also countries generating a surplus. The West should learn to consume less and save more, while the East should learn to consume more. For instance, we can expect China’s influence to grow even further as well as that of the countries of the Gulf Cooperation Council (GCC). There has also been more and more talk of the G20 group of countries having the potential to take over the role of the G7 countries in world economy in shorter or longer perspective.

The rebirth of classic banking

The extensive spread of derivative instruments in the recent past had long ago stopped following the development of real economy and started living its own life, which in the end caused the evaporation of huge amounts of assets (albeit mostly virtual assets) as a result of the crisis on financial markets.

“The new world order” also means that banking is simpler, more transparent and less prone to risks. The banks’ profits will decrease and the responsibility in assessing the creditworthiness of customers and the risks involved in financial transactions will increase and therefore risk-adjusted income should not considerably drop. The retail and investment banks operating in a noticeably stricter legislative framework than today will be balanced by the sector of hedge funds, private equity funds and real estate investments with greater freedom of operation (though rather more limited and regulated than today).

Governments involved in banking

Governments, particularly those who have taken control of or acquired a significant holding in some large banks in order to “save” them, will be increasingly intervening in the activities of the financial markets. The new, partly state-owned banks will besides the owners’ interests presumably start paying more attention to public interest, which in turn will put pressure on other, the so-called ordinary banks to behave in a similar manner.

Aiming at zero-risk banking

The financial crisis also directed the focus towards questioning the possibilities, capabilities and weaknesses of international banking and financial services supervisors, referring, among other things, to the incapability and inadequacy of the highly praised Basel II framework in the timely identification of risks. Future regulations will have to try to specify the definition of capitalisation in even greater detail and certain pressure will probably be exerted to increase the rate of mandatory (reserve) capital. This will not be an easy task by far, even more so as it is clear that there is point in having international regulations only if the rules of the game are same in all the countries of the world. As a result, the corresponding agreement of the G20 countries would have considerably more potential that that of the G7 countries.

Unforeseen fiscal pressure in many Western countries

The Estonian state has not had to spend the taxpayers’ money to save banks, but for instance in the USA, Great Britain, Spain and Ireland, where the consumers’ loan burden is relatively high and the value of real estate property has dropped the most, governments are under great pressure to increase tax revenue – if not in the short-term, then definitely in the long-term perspective. This puts countries under severe pressure in the general economic recession situation, even more so because they also have to maintain the profitability of the partly state-owned banks and keep the banks attractive for future buyers.

Time to wake up from hibernation

A large part of the world’s financial institutions have fallen into passivity similar to hibernation – which is a somewhat understandable reaction, given the extreme circumstances. In crisis situations, there is always a tendency to start dealing with urgent day-to-day matters, “momentarily” losing the long-term focus. But in the changing conditions, namely those banks and companies will stand out, who are able to make the transition from merely ensuring their survival to a new strategy that is successful and sustainable in the long-term – or find a way how to emerge from the crisis as winners.

Article is based on PricewaterhouseCoopers’ study “The Day after Tomorrow”.