Beyond the Sub-Prime Crisis

Seeking growth amid increased uncertainty and shifting sources of profit

by Nader Farahati
Rouget Pletziger

In 2007, the threat of a reversal in the fortune of U.S. mortgage markets, predicted a year ago by Oliver Wyman, became a reality. The well-documented mortgage meltdown and the ongoing liquidity crunch have left the financial services industry in a state of uncertainty. As a result, global growth for the industry—which had been considerably above its long-term trend line from 2003 to 2006—was disrupted and so was investors’ trust.

The aggregate global value of all quoted financial services firms fell by 1.7% to a total of $10.5 trillion. At stable exchange rates, the industry would have even seen a value loss of 7.2%. Moreover, financial services has become a twospeed world in which mature economies (with the exception of Australia/New Zealand) see a mean reversion, and emerging markets still enjoy a stellar performance fueled by inflated asset prices. Below this high-level perspective, performance skews across sub-sectors and individual institutions widened significantly.

We expect further turbulence for 2008 and beyond; recently, in fact, there have been signals of wider and sustained market volatility. Significant additional sub-prime-related losses, write-downs, and business collapses sparked new shocks in global equity markets, this time equally affecting emerging markets and prior winning sub-sectors, such as exchanges and asset managers. Governments, central banks, and other external parties have come to believe in the real threat of a wider recession, not least since the latest bold cuts of the U.S. Fed fund rate.

With regard to share-price stability, the full impact of the ongoing credit and liquidity crisis is unlikely to manifest itself before the end of 2008. Analysis of historical crises shows that even if the profitand- loss hits stopped today, consumer confidence would not return for another three quarters.

Beyond sub-prime-related market uncertainty, our outlook for 2008 and 2009 flags four new risk scenarios that could cause additional losses and volatility for financial services:

This view on future conditions is not shared by all parties in the industry. A large number of financial services CEOs we surveyed are assuming business as usual—implying continued capital and resource allocation to existing operations— even though short-term growth predictions were well off 2007 actual results. For 2008, CEO predictions suggest further industry growth of 5-14%, with 69% of survey participants expecting their firms to outperform the industry.

Underperformers and Premier Performers

Oliver Wyman’s Shareholder Performance IndexSM (SPI) is a global measure of relative riskadjusted shareholder performance. It reacts to slowdowns in growth as well as to increased volatility, and helps characterize likely future underperformers. To develop a profile of the firms most exposed to future disruptions, we examined “steady underperformers”—firms with SPI scores consistently below the averages of their respective sub-sectors and regions over periods of three, five, and ten years.

The disruption in 2007 illustrates the sensitivity of steady underperformers to future crises and the predictive strength of the SPI measure: Steady underperformers as of June 2007 faced significantly larger hits by subsequent events than did their peers. Additional conclusions are that macro crises can crystallize almost anywhere and that being struck involves more than simply bad luck.

Premier performers, by contrast, remained strong after a turbulent year. Firms such as Sberbank, Russia’s largest banking institution, and T. Rowe Price, the U.S.-based asset manager, provide models for thriving in a volatile world, where the winning formula for future outperformance will consist of two main pillars.

First, excellence in risk and resource management needs to take center stage in the short term. Quick wins include the review of lending standards and limit setting, adjustments to approval processes and the review of earlywarning tools and exit instruments. In addition, senior management should pay close attention to liquidity and internal sources of funding, talent, and a strategic alignment of cost management. Second, delivering the required performance levels requires gearing to controlled growth.
Firms need to deepen and expand their existing core profit zones, while finding the right levels of focus and innovation. This has different implications for different business models (e.g., generalists vs. specialists), but will in many cases lead to premier performers exploring new propositions and selective add-on investment opportunities in adjacent businesses. The active management of strategic risk, in alignment with available capital and resources, becomes one of the key related medium-term
success factors. Growth Opportunities Where Traditional Businesses Intersect Surveyed CEOs continue to seek new growth primarily in their domestic markets and through organic expansion into new areas. Product and service innovation remains at the forefront of cited strategies to counter increasing customer demands, with talent management  and the alignment of internal governance models representing major challenges. Sources of profit are increasingly shifting to the intersections of traditional sector boundaries.
New cross-sector approaches include these examples:

Industry Evolution in the Medium Term

Recent events have exposed failings in certain areas of risk and liquidity management, as well as other excesses that require correction. Yet we still believe, unlike some commentators, that the established trends of modern finance will remain intact and are headed in the right direction. We are not witnessing the predicted collapse of modern risk management or the fundamental failure of a financial services business model that is based on the parsing and distribution of risks to the most efficient holders of that risk. If appropriate corrective actions are taken, the industry should emerge both stronger and more dynamic, with “originate and sell” and advanced risk transfer models to grow in new conditions—most importantly, these:

A healthy next round of consolidation will favor those institutions that are prepared to cope with this medium-term evolution, and it provides windows of M&A opportunity and easier access to talent.

Against this background, CEOs and senior executives have a few high-priority items for their agenda. They will need a much tighter grasp of potential exposures and contingency plans for any worsening in the markets. They will have to anticipate how the sources of economic profit are shifting toward new regions, customer segments, and value propositions. And they must contend with new forces, including giants in emerging markets and sovereign wealth funds, which are not directly affected by the current crisis and are at the forefront of innovation in 2008.