The importance of capital markets and the need for global entities to have access to capital cannot be over stated. With today’s focus on global regulation along with issues in the currency markets and Asia, extraordinary things are happening that are changing the way the world obtains and utilizes capital from banking and non-banking sources.
What are Capital Markets?
Ever wonder what capital markets are all about? The simple explanation starts with the words money and markets. Capital markets are markets where money is exchanged between people that have excess money to those that need money. People or companies use the money for uses such as expanding operations.
Participants include the major banks and some of the private equity players. Users are those people that need to access these markets such as a company that is in the process of conducing an IPO. It could also be pension funds looking to invest capital or insurance companies that have long dated liabilities.
The providers of capital fall into regulated entities such as banks, and unregulated entities commonly referred to as the shadow banking system. If one company directly lends to another, this would be considered part of the later.
Rising Interest Rates
Rising interest rates impacts the market in two ways.
- Increase in Hedging: Companies that have not engaged in hedging activity will have higher costs of capital. These firms will quickly work with outside companies to help hedge that risk.
- Growth in Fund In-flows: One of the dynamics of the overall loan market has been the in-flows and out flows of the individual investor. With interest rates rising, these funds will become more attractive with more in-flows into these funds.
A recent study by PwC identifies capital markets trends and how these trends will impact the markets.
The study describes how one unexpected consequence of increased industry regulation is a shrinking of the top 15 or 20 firms that have dominated capital markets.
This gap is being taken up by regional banks and private players such as pension funds or sovereign wealth funds. The result is a more fragmented market with multiple tiers ranging from big firms to smaller firms that are referred to as the shadow banking industry. Shadow banks are firms that provide funds outside of the regulated industry
Predictions Made by PwC
- The emergence of a new financial center in addition to New York and Europe.
- Disruption due to cyber terrorism on financial infrastructure of the markets.
- The future structure of financial institutions needs to be more cost efficient
Smartly, PwC recommends that companies engage in a workshop that develops a game plan based on potential competitive situations.
The Role of Currency
So far most disruption has been seen in payments and lending. Going forward, disruption can take place in unexpected places such as cyber currencies, particularly if it is more efficient than traditional currencies.
Impact on Risk and Liquidity
One result of the aforementioned changes is a shift in the way major financial institutions calculate the risk associated with the use of capital along with changes in the ways that users of capital manage cash. One example of this change is how upper income individuals in the U.S. are holding 20% of their net worth in cash instead of the historical level of 10%. Institutions such as sovereign funds and corporations are also holding record amounts of cash, placing a tremendous amount of liquidity in the market.
Last, being an investor today is fraught with peril as there are too many investors looking for yield in places that represent a variety of risk profiles. On the lending side, regulations are causing a shift away from lending by a small group of entities (major banks) to a spreading of risk to more entities that are willing to lend in exchange for higher interest rates.
Impact of Regulations on the Lending Markets
Every bank capital markets participant in the marketplace feels regulations. The leveraged lending guidelines are forcing the banks into a specific box. The non-banks are playing outside that box. Both factors have caused total leverage come down considerably. This will probably continue over the next year or so.
After 2008, the pace of regulatory change accelerated with banks starting to manage to Basel II. These regulations changed the risk profile of capital resulting, raising the cost of lending, making loans to the middle market less profitable. After all, why lend to the middle market, when loans to larger institutions require the same work while generating higher margins. The result was a bank pullback of lending to the middle market.
As the costs of doing business increased, small loans passed from banks to companies that could operate with lower costs such as private lenders and subordinated lenders.
There are a number of instances where banks can no longer do a deal, causing a shift to non-banks. Today in the U.S. we are a non-bank market. In Europe, because of the stress on the banks and the need for capital, you are seeing institutional money replace the banks.
One positive outcome of the change in capital markets is that the shift to loan activity across a larger number of institutions in and of itself reduces systemic risk. Today, the number of business loans to business from banks is less than 20%. The role of a bank is more of a mortgage banker underwriting research. Most countries have not experienced this phenomenon like in the United States. In Europe, the banks own most of the loans.
Banks needs to either get permission to push the envelope in terms of regulations or they will pass. That said, there could be some rollback on regulations as unintended consequences of regulation are revealed.
The slow pace of growth in the U.S. economy lags the stronger performance in the mortgage market. Consumers are finding the financial freedom that comes from an affordable mortgage which has been a boon to estate attorneys, financial planners and brokers. At the same time, foreclosures and delinquencies are at a 10 year low. Even though housing prices continue to increase, improvements in employment appear to be an off-setting dynamic. Wholesale mortgage providers such as Freedom Mortgage Wholesale see improvements in loan quality and credit quality.
Clouds on the horizon include the intent of the Federal Reserve Board to raise interest rates. Even this is not a primary concern since the Board has assumed an accommodating posture with future increases expected to be gradual. Small increases promise to keep the 10-Year Treasury benchmark below 3%. Related 30-year mortgage rates are expected to stay below 5% for at least the next two years. (Source: Mortgage Bankers Association).
One over-riding factor in the mortgage market is the number of expected new home starts (expected to grow from 1,114M in 2015 to 1,235M in 2016) and originations. With demand continuing to increase, we can expect improvements in the wholesale mortgage market and among direct lenders.
Challenges Faced by Executives
Executives today are in the same position they were last year. They need to understand the ACA tax regiments and the role of government in areas where they haven’t been before. The rising dollar is also affecting business in terms of global competitiveness.
What we are seeing today in Europe and in the U.S. is an expansion of the convertible bond market. These are being provided from sources other than the banks.
Capital markets are more important than ever. If you look at what is happening in the work in terms of population and infrastructure, there are huge demands for capital. Countries will not be able to satisfy these needs locally, fueling a global marketplace for capital.
The players in capital markets will need to accommodate new sources of capital, particularly with the regulatory burden.
A long term view and vision is needed to take into account the macro trends. Institutions and borrowers will need to be flexible in managing through rapid market change.