Financial crises present the private sector with a unique opportunity and a financial self-interest in resetting the basic standards and safe- guards that should prevent or reduce the impact of future crises on shareholders, customers, and employees.
In Chapter 8, “Strengthening System Safeguards,” we begin the final part of our book by arguing that crises in fact afford individual companies and firms with opportunities to reset their financial policy environments. Stan- dards and safeguards can be strengthened along all three levels of a compre- hensive crisis prevention safety net—self-governance; market supervision;
and government regulation—which we believe is essential to protect economies from crises.1
The first opportunity is in corporate governance, which is a core com- ponent of the first tier of our safety net. Effective boards provide a good
“check and balance” on management activities. Today, global investors
demand good corporate governance. They expect disclosure, transparency, management accountability, and ultimately a strong commitment to share- holder value through sound corporate governance, and they will pay for it.
Effective boards act as a first line of defense to value-destroying activities in the private sector. Our series of McKinsey surveys, in fact, reveal that investors would pay a premium of as much as 30 percent for well-governed companies in emerging markets. Moreover, our ongoing research reveals that executives in emerging markets can expect as much as a 10 to 12 per- cent improvement in their company’s market value in exchange for improv- ing corporate governance along multiple dimensions. As a consequence, the private sector has a real self-interest in enhancing corporate governance standards following a crisis.
Deep and efficiently functioning capital markets comprise the second tier of our crisis prevention safety net. The private sector can also influence capital market reforms, including pension fund reforms. It can help promote the strengthening of domestic capital markets, especially debt markets. A vibrant market for corporate control, one in which a company can be taken over and bought and management replaced if it fails to perform in ways that increase shareholder value, will also enhance an economy’s resilience to cri- sis. Such reforms are necessary since well-managed companies need to raise investment capital at the lowest cost. Effective capital markets can have sev- eral benefits, including channeling funds to their most appropriate use, pro- viding better pricing of differentiated risks and more timely repricing of financial assets, and attracting a more robust mix of investors that play important but different roles in an economy.
In this third tier, private sector leaders can also influence the direction of a new regulatory and legal landscape that emerges after a financial storm.
There must be clear supervisory and examination policies and processes.
There also must be well-drafted, transparent, and neutral statutes and codes for general business law, investor protections, creditor rights, and financial transactions integrity. These legislative changes and legal codes must be administered well, with adequate judicial review and other protections against abuse. Speeding up bankruptcy proceedings and resolving disputes between and among creditors and debtors more quickly are critical. Re- examining the relationship between law, regulation, and supervision is also required.
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Finally, the private sector must step up collectively and play an even greater role in shaping a new, more market-based global financial archi- tecture that will minimize and prevent future crises and lay the founda- tion for less dangerous markets and more sustained economic growth.
We believe that investors and intermediaries need to explore the creation of a new, market-driven financial architecture, with global standards and safe- guards that are as broad in scope and ambitious as the old Bretton Woods Agreement, but which are driven primarily by the private sector.
In Chapter 9, “Designing a New, Market-Driven Financial Architec- ture,” we come to the conclusion that private sector leaders in both devel- oped and emerging market economies—financial market makers, fund managers, private equity investors, direct foreign investors, and intermedi- aries such as leading investment and commercial banks—have a self-interest in robust and resilient financial markets to deliver shareholder and customer value and a global financial system that is safer, less dangerous, more effi- cient, and more effective at preventing future crises.
The private sector cannot afford to stand back and wait for the existing protagonists, such as the IMF, the World Bank, or the G-7 nations, to sort out needed crisis prevention measures on their own. The costs are too high and their speed of action is too slow. Moving to a new, world financial order has to include active involvement and leadership by private sector leaders in decreasing the frequency, duration, and costs of financial storms in the future. For instance, moving under private sector leadership to a single set of prudent, fair, and systemic standards and safeguards across multiple dimen- sions could have an enormous impact, not only on the global financial archi- tecture but also on entire nations and the societies they represent.
Moreover, there is much that leading companies and their senior execu- tives can do to set their own standards of business conduct, governance, and transparency. There is nothing to stop the leading institutional investors and pension funds, for example, from significantly accelerating how they man- age by, and report their compliance with, those same standards in the course of their normal business. Organizations such as the International Corporate Governance Network (ICGN), the Institute of International Finance (IIF), and the International Accounting Standards Board (IASB), among others, are making significant strides, but more action needs to be taken to make standards and safeguards more effective and more credible—with real mar- ket incentives for success and equally strong penalties for failure.
For example, what if there were universally accepted, enforceable stan- dards to determine when banks fail, so that depositors and taxpayers could be protected more than they are today? What if there were a groundswell to strengthen local capital markets and more efficient linkages to the financial hubs to lower the cost of capital to all end users—consumers, small busi- nesses, large corporations, and governments alike? What if the governance, transparency, and accounting standards to list on either one of the world’s two financial hubs were universally accepted as the new standards enforced globally in all markets? Suppose everyone could agree on the key skills and
sets of experiences that CFOs and their risk management teams must have to help manage any company? What if there were private insurance for loan portfolios to take the pressure off underfunded and poorly designed national deposit insurance schemes?
All of these ideas are not just academic questions; rather, they are ideas that need to be discussed and debated by those private sector leaders with the greatest degree of self-interest in preventing future financial crises. We believe that these same leaders can seize the moment and start to create a new, global financial architecture that promotes sustained economic growth while avoiding financial crises.
We will advance this position one step further. In our view, the process or mechanisms to ensure a more effective global financial architecture could easily include the forming of a self-governance market mechanism to deter- mine what standards and which safeguards will guide financial market behavior and commitments to shareholders and customers.
On a global scale, a financial market self-governance organization (SGO) would go a long way from our perspective to set and monitor these standards and become a central database for information, education, and skill transfers. The agenda we recommend contains a starting point for stan- dards in an effort to reduce the dangers and costs that financial crises impose on companies and societies alike.
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Of course, there are other components of our vision to manage financial crises effectively and lessen their future impact. In the following chapters, we describe what our practical consulting experience has taught us about surviving and prospering in financial storms. These are the real world les- sons that we believe will make individual companies, national financial sys- tems, and, ultimately, the global financial order safer from financial crises, more resilient and resistant to dangerous markets, and more conducive to supporting real economic growth and development in the years ahead.
I
Understanding Financial Crises
2
Recognizing New Global Market Realities
On September 16, 1992, financier George Soros challenged the British government to one of the highest-bidding poker games in history, betting that the British had overvalued the pound relative to the German deutsche mark and other European currencies. With an investment of $10 billion, Mr. Soros won, forcing the devaluation of the pound—and walking away with a $950 million profit.1
Mr. Soros is still known as “the man who broke the Bank of England,”
but the effect of his actions went farther than a single man and a single event. Prior to this event, the reserves of the major central banks around the world were thought to be enough to counteract any movement in currency values. Mr. Soros proved that the power and volume of daily currency trad- ing had far outstripped the reserves of central banks. Indeed, that power shift from governments to private financial markets had occurred years before—in 1986 (Figure 2.1).
Today, as we enter the twenty-first century, we are far from the days of the Bretton Woods Agreement, when markets were stabilized by fixed exchange rates and capital mobility was strictly regulated. Since the collapse of the Berlin Wall in 1989, the combination of economic liberalization, rap- idly falling communications and transportation costs, new digital technol- ogy, the adoption of global standards for business, and increased mobility of capital has swept away historic market barriers. Larger, ever more inte- grated global markets have replaced closed national ones, and the familiar geographically defined market and industry structures are in flux. Businesses can now build on new economies of specialization, scale, and scope, both within and across countries.
Nowhere have these changes been more dramatic than in the world’s financial markets. Formerly closed, tightly controlled financial systems that were dominated by banks (and often governments) have been replaced with free-flowing capital across borders. Decisions are no longer in the hands of 19
the few, as the Bank of England learned, but rather in the hands of millions of individual issuers and investors, primarily large institutional investors.
Markets, led often by mavericks like Mr. Soros, reward the winners and ruthlessly cull the losers. The use of financial derivatives has skyrocketed, both to hedge risk and to magnify potential gains or, inadvertently, losses.
New types of financial contracts are being developed continuously to isolate and price specific risks and trade on future financial streams. Around the world, physical assets are increasingly becoming securitized and traded.
This new financial landscape has many benefits. Investors have more ways to diversify their portfolios and earn higher risk-adjusted returns.
Those with the appetite can now take on many new types of risk; those without can hedge risk or sell it altogether. Cash-strapped companies can tap into a larger pool of global capital, unlimited by the paucity of financial capital in their own countries, and lower their cost of capital by doing so.
Over the 1990s, the risk premium associated with both bonds and equities declined across nearly all asset types: capital was getting cheaper. Although this trend has reversed in the last few years and has perhaps overshot its equilibrium value, we believe that the long-term trend is toward cheaper capital as markets become more efficient.
More important, from our perspective, is the fact that many emerging markets have opened up their financial systems to the world of global capital.
0 200 400 600 800 1,000 1,200 1,400 1,600
1983 1986 1989 1992 1995 1998 2001
0 200 400 600 800 1,000 1,200 1,400 1,600 Average daily
turnover in global foreign exchange*
Central bank reserves for
G-7 countries**
DAILY CURRENCY TRADING OVERWHELMS CENTRAL BANK RESERVES
$ Billions
*Foreign exchange turnover includes spots, outright forwards, and foreign exchange swaps
**Total reserves minus gold; G-7 countries include Canada, France, Germany, Japan, Italy, UK, and US
Source: Central Bank Survey of Foreign Exchange and Derivatives Market Activity, BIS; IMF—
International Financial Statistics; literature search
FIGURE 2.1 Daily currency trading overwhelms central bank reserves.
Almost without exception, however, they have done so without the appro- priate market infrastructure and standards in place. Bank supervision, accounting and governance practices, and legal protections were all insuffi- cient to permit the efficient, stable functioning of financial markets. As a result, financial crises are now more frequent, more costly, and have more spillover effects on businesses and investors outside the crisis nation. Look- ing ahead, it is clear that we are now in a new era of financial instability, in which crises are an increasingly common part of the landscape. No man- ager—and particularly those operating in dangerous markets—can afford to dismiss or underestimate the risks.
In this chapter, we examine the empirical evidence on the frequency and cost of financial crises that have led us to our admittedly rather bleak view.
We then turn to why crises are on the rise, and look at the dynamics follow- ing financial market liberalization that engendered the crises. (See Box 2.1:
What Is a Financial Crisis?) In fact, we believe that there are two main rea- sons why financial crises occur more frequently today than in the past.
BOX 2.1: WHAT IS A FINANCIAL CRISIS?
Financial crises are admittedly difficult to define and often have no pre- cise beginning or end. A World Bank staff report defines them as financial events that eliminate or impair a significant portion of a banking system’s capital.1We believe, however, that crises have two fundamental dimen- sions: One is financial, the other is panic, which often is the trigger.
First, debilitating and massive shocks to bank liquidity, payments systems, and solvency are obvious characteristics of financial crises. Typ- ically, there can be a crisis of liquidity and cash flows, in which deposi- tors cannot withdraw their money and companies cannot get the credit they need to run their operations simply because banks have exhausted their cash reserves. There can also be disruptions in the payments sys- tem, in which everyday settlement and clearances of consumer and busi- ness transactions grind to a halt, become difficult to unwind, and place those expecting cash at the end of the day in the unfortunate position of being unsecured creditors overnight. There also can be a crisis of sol- vency if banks are forced to write off huge losses and equity capital is significantly impaired or lost. Any of these problems in an individual bank does not necessarily constitute a crisis; but it only takes a few large, failing institutions or a group of smaller ones (e.g., Thai finance companies, Korean merchant banks) to lead to a systemic panic.
(continued)
The first is simply that more and more emerging markets are linking up with the global financial system, and many of them are doing so before ensuring that the appropriate safeguards and standards are in place (e.g., accurate accounting and transparent financial reporting, adequate risk man- agement and asset-liability management skills, good corporate governance, adequate market regulation). In tandem, the greater liquidity of capital mar- kets in developed countries increases the depth and reach of crises across developed and developing markets alike.
The second reason is that the large and rapidly growing global financial system is much more interconnected and closely integrated now than at any time in the past, making it more susceptible to contagion. In other words, except in cases like North Korea and Cuba, one can no longer “wall out”
adverse situations in one part of the financial system.
All of this leads us to conclude that “you can run—but you cannot hide.” In today’s interlinked global economy, no one is safe from the destruction of financial crises. The warning signs must be recognized, and you must prepare for the storm.