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Big Shift in Risks Could Reshape Financial Industry

Gains in asset management amid a decline in sales and trading are challenging institutional banks to reconsider their risks and opportunities.

Morgan Stanley Blue Papers, a product of our Research Division, involve collaboration from analysts, economists and strategists across the globe and address long-term, structural business changes that are reshaping the fundamentals of entire economies and industries around the globe.

Falling market liquidity—largely the result of financial regulation and central bank stimulus—is beginning to worry policy makers, who are trying to transition out of loose monetary policies, first in the US, and next in the UK. Because so many mutual funds, which offer daily liquidity, now own corporate bonds, some policy makers worry about the potential impact to the global financial system in case of widespread redemptions.

As a result, the risks have shifted from the sellside (merchant and investment banking) to the buyside (asset managers) of institutional banking. The former is heavily regulated and stress-tested to ensure that it can withstand major market shocks; the latter are likely to face greater regulatory scrutiny, argue Huw van Steenis of Morgan Stanley and Christian Edelmann of Oliver Wyman, the lead writers of the latest jointly produced banking industry Blue Paper, “Liquidity Conundrum: Shifting Risks, What It Means” (Mar 19, 2015).

Here are some key takeaways from the report:

  • Asset managers are likely to face an initial set of incremental regulatory reforms to stress-test select funds; large banks already dealing with stress-testing of other businesses are better-placed to absorb the additional costs.
  • An analysis of worst-case fund redemptions in the past 35 years found that most funds today have enough cash (4% to 7% of holdings) to meet outflow from fixed income mutual funds of 5% on average during the worst three months in 1994.
  • Institutional banks’ balances sheets, which have already shrunk by 20% since 2010, could contract by another 10% to 15% over the next two years, amid tighter regulatory requirements.
  • US credit markets may experience a rebound as the Fed gets ready to raise interest rates; but Europe, which is just beginning its own QE regime, faces tougher times, adding more urgency to the need for a European Capital Markets Union.
  • Merchant and investment banks are likely to speed up the pace of structural changes, with midtier banks able to achieve higher returns in niche markets, while the strongest institutions benefit from streamlining and opportunities arising from the retrenchment of weaker competitors.

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