How leaders handle these new fundamentals will dictate future jobs, economic growth
With the European crisis continuing to dominate the news,
many people now realize that today’s global economy faces an unusually
uncertain outlook. Indeed, Europe’s turmoil is but one of the multiple global
re-alignments in play today. What may be less well recognized is the extent to
which specific sectors are already changing in a consequential and permanent
This is particularly true for global finance where
volatility has increased, liquidity is evaporating, and the role of government
is pronounced but inconsistent. This is a sector where the functioning of
markets is changing, along with the outlook for institutions. The implications
are relevant for both economic growth and jobs.
The recent volatility in financial markets – be it the
dizzying swings in equities around the world or the fragmentation of European
sovereign bonds – far exceeds what is warranted by the ongoing global
re-alignments. We are also seeing the impact of a consequential shift in
underlying liquidity conditions – or the oil that lubricates the flow of the
credit and the related ability of savers and borrowers to find each other and
Facing a range of internal and external pressures, banks
seem to be limiting the amount of capital that they devote to market making.
Combine this with the natural inclination of many market participants to
retreat to the sidelines when volatility and uncertainty increase, and what you
get is a disruptive combination of higher transaction costs, reduced trading
volumes, and abrupt moves in valuations.
We are also witnessing a loss of trust in instruments that
many market participants – from corporations to individual investors and
institutional ones – use to manage their balance sheet risks. The reduced
ability to hedge current and future exposures is even forcing some to
transition from using markets to manage their “net” exposures to simply
reducing gross footings.
Meanwhile western banks, whether they like it or not (and
most do not), are now embarked on a journey – away from what some have called
“casino banking” to what others label as the “utility model.” Whether in
America or in Europe, banks are under enormous pressure from both the private
and public sectors to become less complex, less levered, less risky and more
By withholding new credit, private creditors are forcing
certain banks to de-lever – a process that is amplified by the sharp decline in
bank stocks and the accompanying erosion in capital cushions. At the same time,
the banks’ traditional global dominance is under growing competitive pressures
from rivals headquartered in healthy emerging economies.
The result of all this is a further, across-the-board
shrinkage in the balance sheet of the western banking system. This is led by
Europe where some institutions (eg, in Greece) are also experiencing meaningful
After the 2008-09 debacle of the global financial crisis,
governments also want their banks to be better capitalised and more
disciplined. And while implementation has been both far from consistent and
less than fully effective, the intention is clear: Much tighter guardrails and
better enforcement to preclude any repeat of the Wild West experience of
over-leverage, bad lending practices, and inappropriate compensation
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The influence of central banks and governments are also
being felt in other ways that impact the functioning and efficiency of markets.
Some of the implications are visible and largely knowable while others, by
their very nature, are unprecedented and therefore less predictable.
For three years now, central banks have been pursuing a
range of “unconventional policies,” particularly in America and Europe. The
goal has been to reduce the probability of prolonged recessions and severe
In doing so, central banks have gone well beyond their
prudential supervisory and regulatory roles. They have become important direct
participants in markets – essentially using their printing presses to buy
selective securities, and doing so not on the basis of the usual commercial
criteria that anchor the normal functioning of markets.
Market predictability is also being impacted by the erosion
in the standing of sovereign risk in the western world. The cause is the twin
problem of way too little economic growth and way too much debt. The effect is
a less stable global financial system now that there are fewer genuine ‘AAA’
anchoring its core.
All this will translate into a very different financial
landscape. The change will be most pronounced for banks.
Look for western banks to be less complex, less global,
somewhat less inter-connected and, therefore, less systemic. With some banks
teetering on the edge, certain European governments (such as Greece) will have
no choice but to nationalize part of their financial system.
Also, with the western banking system shrinking in scope and
scale, look for new credit pipes to be built around those that are now clogged.
With the aim of supporting growth and jobs, particularly in longer-term
investments such as infrastructure, some of these pipes will be directed or
enabled by governments.
Have no doubt, the financial landscape is rapidly evolving.
Some of the changes are deliberately designed and implemented. Others are being
imposed by the quickly changing reality on the ground.
The ultimate destination is a smaller and safer financial
services sector. When we get there, a better balance will be struck between
private gains and the common good. Banks will be in a better position to serve
the real economy without exposing it to catastrophic risk and harmful abuses.
The next few months will shed light on the extent to which
governments and, to a lesser extent, business leaders are able to properly
orchestrate the process. The more they fall short, the less growth and fewer
jobs there will be.
(Mohamed El-Erian is CEO and co-CIO of PIMCO. The
opinions expressed are his own.)
The new financial landscape, if smaller but more safe for common good and economy, looks more desirable. Thanks for the positive prediction. Otherwise, everything else around is so pessimistic.