Current market climate and industry drivers

The current crisis and its aftermath will have profound implications for the financial services industry and the world economy.

Market crisis and economic downturn

2008 was one of the most difficult years ever for the financial services industry. As the crisis deepened over the course of the year, the problems in the financial industry spread to other parts of the world economy. A precipitous drop in prices across most main asset classes, coupled with deleveraging, resulted in poorly functioning lending markets and a lack of inter-bank liquidity. Banks were forced to recapitalize, sometimes with the help of governments. Hopes that the crisis might be short-lived were dashed after the failure of one of the major US investment banks in mid-September, which resulted in very severe liquidity issues for many financial institutions. Banks experienced a scarcity of equity, credit supply further contracted and numerous countries fell into recession.

Recessions characterized by a simultaneous fall in prices across asset classes, an increase in consumer savings rates and contractions in lending caused by a shortage of bank capital are very rare, and have always been severe. There have in fact only been four recorded instances of such recessions in the past century: the "bankers' panic" in 1907, the "great depression" in 1929-39, the Swedish economic crisis in 1992, and most recently the "lost decade" in Japan from 1990-2000.

Changes in consumer demand drive capital expenditures by companies and consequently affect capital goods industries, sometimes very rapidly. Even countries which have not experienced high leverage growth and significant asset price increases have been affected as investment spending and exports dropped. In particular, countries which relied on foreign capital inflows (either to the government or to the private sector) are at risk of seeing foreign investment and exports fall, which could in turn hurt the value of their currency.

There were radical changes to monetary and fiscal policy during 2008. Government borrowing and spending (through "stimulus packages", transfer payments, loans, guarantees and purchases of bank capital) increased dramatically and led to higher deficits. Central bank balance sheets expanded, both as a result of traditional central bank activity and through unconventional measures such as the purchase of distressed assets from financial institutions (for example, mortgage backed securities). Interest rates have fallen to historically low levels in most countries as central banks attempt to support private and corporate spending.

Macro economic perspectives

The macro economic outlook for 2009 is not positive. A modest recovery can be expected only if the measures taken by governments and central banks prove to be both effective and efficient. Few observers expect the financial services industry to rebound quickly from this crisis.

Industry drivers

A number of drivers are expected to have a significant impact on banks' earnings and the structure of the financial services industry in the short to medium term. The most relevant factors are described below.

De-leveraging

The current downturn is different from previous ones not only in terms of its severity and wide geographical reach, but also in terms of the de-leveraging process that lies at its heart. De-leveraging is the process through which households, companies and the banks that intermediate between them simultaneously attempt to sell real and financial assets to pay back their debts. This unleashes two strong deflationary forces.

First, there is a reduction and restructuring of banks' balance sheets, which may affect their capacity to lend money. Such a restructuring is already well under way, having started in 2007 when banks began recording losses on their asset portfolios, disposing of assets and raising capital. This trend gathered pace in the course of 2008 and has continued in the early part of 2009 as several banks disclosed more losses and raised further capital.

Second, household and corporate balance sheets are also in effect being restructured and reduced, depressing consumer and capital spending and appetite for risk. This process has just started and may last several years, as households address the need to permanently increase their savings. It may be particularly long and painful in countries with historically low savings rates, such as the US.

While debt levels are lower among non-financial corporations than in previous recessions, these companies will also have to restructure their balance sheets as they face falling demand for their products and services, and funding becomes increasingly scarce and more expensive.

The process of de-leveraging is expected to have, on balance, a negative impact on banks' earnings. While increased savings can provide opportunities for certain banks, risk aversion and the downward pressure it exerts on asset prices tend to reinforce each other.

Government intervention and re-regulation

The financial crisis has sparked heavy public intervention in the global financial system. State intervention packages have included a mix of capital injections by governments, public guarantees for selected bank liabilities such as deposits and commercial paper, and maximum loss guarantees for illiquid assets held in banks' balance sheets. Governments have increasingly attached conditions to the measures they have taken, providing them the opportunity to at least temporarily influence the business activities of certain banks.

At the same time, the financial industry and its regulators are analyzing the lessons learned and implementing measures to adjust their business practices and the regulatory framework. This will fundamentally impact and likely transform the industry. While many details of the regulatory response to the financial crisis are still to be worked out, new regulation will likely focus on ways of mitigating the negative effects of the business cycle through regulatory policy, as well as on measures to increase the transparency of financial markets and to strengthen their resilience. Regulators are also likely to try to better identify and address systemic risks, for example by adapting regulatory requirements to the size and profile of certain financial institutions.

Specific measures are likely to include adjustments to the following six broad areas of direct relevance to international banks: higher capital requirements and the introduction of leverage limitations; more robust liquidity buffers and risk management; management and partial reintegration of off-balance sheet exposure onto firms' balance sheets; review of valuation and accounting practices; increased co-operation between stronger and better-equipped supervisors and central banks, especially from an international perspective; and alignment of compensation programs and pay levels with long-term, firm-wide profitability. Some national regulators have moved quickly, including the Swiss Financial Market Supervisory Authority (FINMA; until 31 December 2008 Swiss Federal Banking Commission), which has already defined new transitional capital requirements for UBS and Credit Suisse.

Overall, the regulatory changes prompted by the current market turmoil will have lasting effects on the industry in terms of bank size, business portfolios, controls, capital requirements, profitability and compensation. These will result in significant changes to the competitive landscape. At the product level, regulatory restrictions and greater supervision in areas such as structured products, credit default swaps, and securitization are likely to result in lower margins for banks. Enhanced transparency requirements and disclosure standards for investment products are also likely.

Client behavior and demand

The relationship between financial firms and their clients has seen accelerating change over the past couple of years, for example with the rise of increasingly sophisticated clients (such as leveraged finance investors and hedge funds). However, the corporate and institutional client segment as a whole is expected to continue requiring innovative solutions which cater to specific and unique needs, and span product groups and geographies.

2008 has marked a turning point with regard to the investment behavior of many private clients, and fundamental changes in this behavior are expected in the future. Returns have been negative in most asset classes and many investors have grown suspicious of hedge funds and complex products in general, especially as these proved to be more correlated with equity and credit markets than originally thought.

Internal UBS research shows that private clients' risk appetite is changing, moving towards more "traditional" asset classes such as equities, bonds, cash or precious metals. This trend is expected to have, on balance, a negative impact on banks' income as it results in lower gross margins.

Wealth preservation

The financial crisis has already resulted in a substantial destruction of wealth as the price of many real and financial assets has fallen from the peaks of 2007. Many investors see a risk of further wealth destruction in the current economic climate. During this phase business opportunities for the financial services industry will mostly be in the realm of value preservation rather than return maximization.

Investors have reacted to the current crisis by selling assets, paying back debt and accumulating cash or deemed equivalent. History shows that investors generally need several years to return to more risky asset allocations following periods of financial distress. Therefore, capital preservation is likely to remain a priority for investors and most will seek to do this by holding cash before considering a diversification across a wider range of asset classes and products. On the other hand, an increase in savings by individuals, particularly in countries where household saving rates have been historically low, such as the US, represents an opportunity for banks.

Retirement provisions

The economic crisis does not fundamentally alter the private retirement industry's growth drivers, namely the demographic shift related to falling birth rates and aging and the falling coverage provided by public pension schemes. Despite the drop in the value of their assets in 2008, private fully funded schemes will continue providing individuals with the best investment tools to accumulate wealth for retirement, and savings will continue to flow into them. The ability of public pension schemes to fund themselves over the long term may be limited as several countries are already heavily indebted and running large deficits, including some driven by measures taken to help their economy in the current downturn, while demographics indicate that the ratio of workers to retirees will decrease in the foreseeable future. In some countries, particularly those which have experienced the largest destruction of accumulated wealth due to the crisis (for example, the US and UK, where pension funds are comparatively more exposed to equity markets than in other countries), a pick-up in individual savings rates would provide additional funds, which will partly be invested in private retirement schemes. This, combined with continued demand for specialist advice in wealth management, continues to represent an opportunity for wealth and asset managers.

Corporate restructuring

The corporate sector is generally better equipped to deal with the negative impact of a slowing economy than in previous downturns, mostly due to a relatively lower level of debt. However, a sharp reduction in demand for goods and services across developed and emerging markets and a continued lack of liquidity in credit markets will inevitably impact the corporate sector. Over the medium term, default rates are expected to rise from the historically low levels prevailing before the crisis, and further major bankruptcies are likely. The internationalization of business - particularly expansion in emerging markets - is likely to slow down as the attractiveness of new markets remains subdued and cash flows previously available for expansion are used to restructure balance sheets. In such a corporate environment, most of the opportunities for the banking sector are likely to arise from simple financing requirements, balance-sheet restructuring and asset disposals.

Emerging markets

Strong growth in emerging markets has been a key feature of the boom years in the global economy prior to the crisis, and banks have benefited greatly from strong growth in these markets. Growth in emerging markets is expected to slow markedly in 2009, reflecting the increased interconnections between economies in the era of globalization. Export surplus countries, including those relying on commodities exports, are most vulnerable to a further deterioration in the global economic environment, but also best placed to benefit from a potential recovery. Over the long term, however, banks which have built up a significant presence in emerging markets and serve a wide range of institutional and private clients are likely to continue benefiting from above-average economic growth in these countries.

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