The financial services industry in the Western world is still in big trouble. Maybe not so much a default crisis to the extent that we could even think about collective bankruptcy like 15 months ago, because the government bail out saved us... from that. However, governments paid a huge price for it. Ex-post we can of course argue that - with the system not collapsing - governments did the right thing. But serving bad firms is not a regular task of governments. And the 'too big to fail' argument was used way too easily by many firms in trouble.
The financial services industry was characterized by the following factors:
* Internationalization and Globalization
* Creation of more complex, structured products
* The bulk of client money stayed in relatively straightforward, low-fee, low-turnover products. Even when performance was bad, turnover remained (too?) low. The latter was often the mistake of clients themselves. They didn't listen carefully to consultants and/or didn't even hire one (penny-wise, pound-foolish cost saving behavior). And besides: banks were treated like accountants. They were fiduciary role models.
THE FINANCIAL SECTOR AS ONE BIG HEDGE FUND
There was a growing importance of levered overlay-style products ran by financial institutions as part of their ''own book'' of business. But these portfolios were not really on their own risk / own account. Without the underlying stable client-related business it would never ever be possible to run these risky strategies.
As a kind of natural side-effect of the interest in overlay strategies we also saw a growing interest in volatility-related products (e.g. VIX based).
There was also more talk about agency problems (i.e. conflicts between management on the one hand and shareholders and/or clients on the other) or in other words: doubts about the fiduciary quality of financial firms. Finally! And this was actually not illogical. Let us try to explain it.
With the stable, non-moving basic client business financial institutions have created a good cash flow base. Albeit that fees were under pressure. Reason: growing international competition between financial institutions on the one hand, and a better understanding on the client's side about what a 'good' performance would imply on the other. In other words: turnover and replacement of service providers were getting more common.
The overlay-style portfolios where the financial institutions make their real money made them like hedge funds. But unlike the situation some 10 years ago with Long-Term Capital Management (LTCM) they were hedge funds that used their regular client business as collateral. At first they were used as collateral so as to be able to introduce larger amounts of leverage. When interest rates in the world dropped and the global business climate turned more optimistic due to the successes in Emerging Markets, key decision takers in financial firms in Europe and the US increased the risk levels of their overlay strategies even further. At the same time the fee base related to regular client business was not really growing anymore.
Result: a growing need for more profitable overlay products and/or new forms of products.
Clients treated as dummies, and a business model that avoided the risks of the LTCM hedge fund debacle....did financial institutions create the ultimate money machine for themselves instead of for their clients?