Odd Lots - Episode 12: How a Consultant Foresaw the 2015 Commodities Crash

Episode Date: January 25, 2016

On this episode, co-host Tracy Alloway is joined by Bloomberg Markets reporter Luke Kawa for a journey back in time. As the global elite mingle at the World Economic Forum's annual meeting in Davos, Switzerland, we look back at a WEF gathering five years ago. Back then, the mood was buoyant -- markets had recovered from the 2008 financial crisis and the euro-zone debt crisis had yet to fully unfold. But Barrie Wilkinson, a partner at Oliver Wyman Ltd., wasn't feeling so jubilant. As bankers, regulators, and politicians congratulated themselves for a job well done, he was warning of a brewing crisis that would start with a crash in commodities prices in 2015. Now, parts of his 27-page report seem eerily prescient.See omnystudio.com/listener for privacy information.

Thanks for listening to Oddlots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast Oddlots on Amazon Music. Welcome to another episode of Oddlots. I'm Tracy Alloway, executive editor at Bloomberg Markets. And listeners, you're going to be sad to hear that we've lost my co-host Joe Wisenthall to the global elite, that is. As of recording time, Joe is still at the World Economic Forum meeting in Davos, mingling with people like Kavanaugh. Kevin Spacey and Joe Biden and whoever else. But I'm happy to say that here with me now is Luke Kauwa, who is Bloomberg Markets Reporter and a semi-famous Canadian. Luke, we're both Davos rejects today, right? Yes, Tracy. They tend not to let riffraff like us in there. Yes, this is very sad. Well, on that note, Luke, I thought for this week's podcast, it might be fun to go back to five Davos's ago, by which I mean 2011. When an analyst at a consultant, The consultancy called Oliver Wyman published a report while at the meeting in Switzerland,

and the report was called The Financial Crisis of 2015, an Avoidable History. What I miss, I don't think we had a banking crisis in 2015. We definitely didn't, and we're going to talk some more about that. But I think what the report was really, really good at was kind of predicting the commodities crash and the idea that banks could have losses from bad energy loans. And in fact, we just got through a bank earning season where we did see a whole bunch of them setting aside more money to cover these sorts of things.

Can you whet my appetite a little? Give me a little sample of that out. Yeah, I've got the report right here. Bear in mind, once again, this is five years old now. Here's one thing it said. Based on favorable demographic trends and continued liberalization, the growth story for emerging markets was accepted by almost everyone. However, much of the economic activity in these markets was buoyed by cheap money being pumped into the system by Western central banks.

Commodities prices had acted as a sponge to soak up the excess money supply, and commodities rich emerging economies were the main beneficiaries. So pretty prescient, right? This was written in 2011 and not a week ago. Yeah. Yeah. So I don't want to give the impression that everything in this report has happened. There are some things that it does get wrong, but it's looking pretty good. And I want to bring in the author of The Report, who is a partner at Oliver Wyman.

His name is Barry Wilkinson, and he is the one who wrote this very prescient thing some five years ago in another snowy Davos meeting. Hi, Barry. Welcome to the show. Hi, how then. Just give us a bit of background about who you are and what you do at Oliver Wyman. I'm currently the co-head of Oliver Wyman's finance and risk practice. I guess my specialty is risk management. I've been working at the company for 22 years.

So I've kind of got deep specialties in a number of risk management topics, credit risk, market risk. I work mainly with the big investment banks at the moment. So I've kind of got some specialties around the trading risk management side of things as well. All right. So take us back to January 2011. And you published this report to coincide with Davos. What made you decide to do this? Yeah, well, I think, I guess the main purpose of the report was to encourage banks to focus more on stress testing.

And I think we've, you know, we've seen since then, you know, a large wave of work around, you know, C-Car, EBA, ECB-type stress testing. I actually have a background in, you know, go back to my university days. I used to, you know, be sitting in the lab, building bridges, testing, you know, stress testing, heavy load, lateral wind, you know, trying to twist the bridge. and it basically rolled down to, you know, could the bridge with strand, you know, a certain level of stress. That was kind of what the whole point of the exercise was. And was there any special reason why you chose to release it at Davos? Yeah, well, I mean, I guess we write these annual reports. You may have seen we just released another report more around the FinTech one this year.

I think it was a, you know, we were in the post-crice environment. The feeling I had at the time was, you know, there were still less, to be learned from the previous crisis. And, you know, my sentiment was, you know, being in risk management for such a long period, I'd seen lots of crises come and go. And my worry was that we were very quickly going to lose the lessons learned from the previous crisis. And I wanted to really get out there, this idea that we should constantly be thinking ahead. It's not about thinking about chances of being another crisis.

It's actually there will be another crisis, you know, in the next three or four or five years. And therefore, we should move to a mode of, you know, banning and quantifying, defying the impact of potential crises. Can you take us back to 2011 and for the uninitiated, just explain the basic thrust of your thesis? Yeah, so, I mean, I guess I was trying to get across the idea of, you know, moving more towards, you know, stress testing as a risk management philosophy, and then I used a particular scenario as a way of bringing the whole topic for life, so I thought if I just, you know, focused on the mechanics of stress testing, it would have been quite a dry read.

So I wrote a virtual history, which was basically laying out a scenario taking us from 2011 to 2015, where I was talking about, you know, the commodity price bubble getting, you know, further inflated by loose monetary policy coming from, you know, the Western central banks. You know, the emerging markets countries, particularly the commodities producers, feeling the benefits of that. And then at some point, you know, people realizing that the narrative around, you know, China growing forever, But as China slowed, we'd see the whole bubble burst. And I guess the timing turned out to be quite timely in terms of last year. That really started to happen. Well, so I want to set the scene a little bit.

So this is early 2011. We're two years out of the financial crisis. Markets have gone up. People are feeling pretty good. You have all these politicians, executives, bankers, partying at Davos. And you're sat in a hotel room predicting another financial crisis. What was the response? Yeah, I mean, I wasn't the most popular person at the time with everybody.

Actually, I mean, I'd say there were two camps. So I'd give you two extreme examples. So in one example, I had a risk manager in a bank, you know, coming with her report and saying, you know, asked me to autograph it. So I think amongst the risk management community, it was a feeling that I was kind of standing up for their, you know, their need to kind of point out potential risks, et cetera. At the other end of the spectrum, I hear in, you know, amongst companies, Modity traders, people were talking about, you know, that bloody Wilkinson report.

So I think, you know, that kind of naturally shows the tension you have in a bank that the risk managers are really focusing more on protecting downside risks, worrying about the interests of depositors, you know, debt holders, whereas the front office are more aligned with the kind of shareholder interest and thinking more about upside potential. I think that's a natural tension, which is good. I just think the problem is sometimes it gets out of balance. It can actually get out of balance in either direction. I guess, pre-crisis, it was out of balance in the direction of, you know, short-term upside.

Post-crisis, you might argue sometimes the regulators are pulling it too far in the other direction. But, you know, that's, I think that's a natural tension that needs to be, you know, explored. Well, let's talk about commodities for a second, because, as you've mentioned already, this is kind of a centerpiece of your report. And back in 2011, the commodity space was booming. I mean, I think we forget that now, but it was just... going sort of gangbusters. Why did you decide to focus on the risks in the commodity space?

Well, I think that's the whole point. Whenever you're looking at the next crisis, you should be looking at the current bubble. And any time asset prices are rising at 100% per annum, or I think oil prices rose something like 800% between, their low of $17 up to $120 a barrel or whatever. So, you know, when you start seeing that kind of asset price appreciation, There may well be speculation underlying, but there's normally an asset financing bubble behind it.

And, you know, anything, any kind of financing supporting the assumption of ever increasing prices is always, you know, a recipe for debt problems later. So that was the, you know, if I was looking at potential issues now, I'd be looking at, you know, London property, which is also seeing, you know, lots of rapid increases. So predicting the next crisis, it's really looking at where people are making a lot of money now, really. It's obviously a very contrarian perspective, but there's no, I think, the idea of, you know, there'd be no point focusing on the subprime market now as your, you know, just because that was the previous crisis, you know, it's looking at the next bubble. So we brought up the big thing that you really nailed in this report. That's the commodities downturn and that whole bust. So, but give the opportunity to critique yourself a little. What do you think you missed or what hasn't really played out the way you expected it to?

Yeah, so that's right. So I think we've got to the stage now where the, you know, China has slowed. There is a talk of a crisis centered around, you know, the mining companies, commodities producing nations, as we said, and the poor. What we haven't seen yet is a full-blown debt crisis. And, you know, I don't think we can call it a financial crisis, which was the term we used in the report. And so we see a, you know, debt coming into the equation.

We've seen equity market corrections. We've seen commodity prices corrections. But we haven't seen massive debt restructuring or bad loans. So for my view, I think it's only a matter of time. Before that happens, you know, I think it's already coming to light that there was a fair amount of financing, you know, behind that. And the next step for me, I think, is to take it from the macro level of, you know, Brazil, Russia, and, you know, the commodities producing countries having problems to the micro level of, well, which countries, companies and, you know, are most vulnerable, and which banks are ultimately holding, or which banks are exposed to those threats.

And, you know, if there is any toxic lending out there who's holding it and are they well capitalized? And I think that really calls to, you know, coming back full circle to as recommending more stress testing. I think the US and European systems have now adopted stress testing as a kind of institutional thing that they run every year. I think the emerging markets regulators, you know, how? having had a less severe crisis this time around, haven't really pushed through the same measures. So I think, you know, I would be calling now for, you know, the emerging markets regulators to start taking a look at their individual banking systems and, you know, looking at individual institutions and running, running stress tests along the lines of, you know, further deterioration. Well, just on the banking point, one other thing you kind of point out in the report is this idea that a lot of risk has actually been squeezed from the banking system into what's known as the shableness.

banking system. So non-deposit-taking institutions, I guess, might be the standard definition, although some people would disagree with me. Can you talk a little bit about that thesis? Yeah. So I think that, you know, I think broadly that hypothesis has played out. I think it's quite difficult to back-test, you know, some of the specific things we said because, you know, by its very nature, it's kind of lurking in the shadows. And as we saw with, you know, the previous round of shadow banking, all these kind of sieve-light vehicles that were hidden off balance sheets. Not a lot of people know about these things until

the crisis hits and then suddenly a bank has to reconsolate this, you know, off-balance sheet activity. So there may well be a new phase of that where it could be the Chinese banks this time having to reconsolate, you know, all of these trusts back onto their balance sheet to, you know, to save face or whatever. But, yeah, it's very difficult to say where all that stuff is currently lurking.

But it's pretty clear, you know, the banks have definitely been feeling the squeeze. So, you know, a lot of the big banks have gone from having a, you know, a two or three trillion dollar balance sheet down to now, you know, one and a half trillion dollars. And at the same time, you know, it's difficult to put numbers around, but any report you look at that you tend to see, you know, kind of a growing shadow banking liabilities at the same time. So I suspect there's quite a lot out there. So it's five years after you published this report. Have you been back to Davos since then? I haven't. I mean, we go there every year.

It's usually the author of that year's report who goes and attends alongside a couple of our more senior guys. So it's, I haven't been back. I mean, I have been thinking of doing a kind of, you know. A victory lap. A new report. Yeah, I could do. but just more of a, you know, maybe next year, some more forward-looking views on risk management and finance and all that kind of stuff.

So what are you looking at right now? What's next on the horizon? Yeah, well, actually, as I say, I think, you know, looking back on the previous crisis is often not the way to think. So if I'm looking at the financial service industry now, what we've been focusing on this in this new report is really that's disrupted forces. So, you know, rather than it being a crisis that hits the banking system next time, maybe it's the, you know, somebody coming in and completely disrupting the cost structures of the banking system. And that could be equally, you know, equally deadly for some of the banks if they're not able to adapt.

I think there's some of the things you mentioned in this year's report is more around, you know, it's actually the regulators are actually helping the banks that create, you know, barriers of entry for new players. those barriers to entry were not there, you know, finance is the ultimate commodity in many ways. So, you know, it would ultimately just be about who's got the best technology and the best cost, cost structure to deliver that commodity. But at the moment, having access to the central bank, having access to, you know, deposit insurance just gives, you know, banks a massive advantage that they will, I think will preserve their position for quite a while. But I think at some point, you know, we've seen the payment part of things getting picked off. I think at some point different part of the value chain will start to get eroded by these new players. I think that's a

big threat to the banks. Yeah, on that note, I mean, I have to say we have seen at least one disruptive FinTech player lending club ask for access to central bank facilities, which is pretty amazing and would potentially put them on a more even footing with banking competitors. Exactly. I mean, one way, one direction you can take it is in the direction of, I think the most difficult bit to disrupt is the maturity transformation side of things. So in order to play the maturity transformation trick, when you get the run on your liabilities because you're playing the maturity transformation trick, you know, if you can turn to the central bank access, you obviously can then weather a few cycles. And if you don't have access, you can't. So, you know, we've been thinking about whether you could, you know, the central bank could, you know, the central bank could, you know, set up some kind of utility which kind of centralizes the maturity transformation aspect of things and then allows people to tap into long-term sources of funding and then, you know, lending then just becomes a commodity and similarly, you know, investing in short-term liabilities is another commodity. So you'd have kind of the money market funds type, you know, part of the

value chain. You'd have the pure lender and then you'd have this money market, three money transformation utility sitting in the center. So maturity transformation comes back on the central bank anyway during the crisis, then maybe they should be managing it in the first place. So it's just a sort of a utopian thought of this point. But I think that's where you'd need to get to if you really want to open up competition across the core products of banking. And to go back to 2011, one of the lines from your report that really stood out to me was

The market was once again rewarding the riskiest strategies in reference to investors' treatment of banks around the 2011 period. And I wanted to know, the market doesn't seem to be rewarding much right now. What are the risky strategies out there right now that you think the market's rewarding that it might not be? It's a lot more complicated now. I think in the days where you could basically create shareholder value just by increasing leverage in your bank.

you know, increasing leverage just multiplies your return on assets by your leverage and creates return on equity. And then it was, and also that leverage also makes it look like you're growing as well. So you get all these massive P multiples. In today's context, you have, you know, regulators looking at you, thinking that you're too leverage and then suddenly forcing you to raise capital, which, you know, is never great for share prices. So it's a lot more complicated. I guess the most successful strategies, which I wouldn't necessarily condone, would be the ones where you can basically take on more risk and more leverage and then, you know, outside of the purview of the regulators who are coming in and trying to clamp down on it.

So, you know, I guess the risky strategies that might be successful in the short term might be the ones that are linked to the kind of shadow banking activities where you can actually take, you know, take risk outside the radar of the regulators. But, you know, again, that's a very short term. It's the approach which will unravel at some point. So, yeah, I mean, I think in general for banks, it's all about costs at this point. I think the, you know, risk is generally a commodity, you know, you generally get paid for the risks, the more risk you take, the more return, you get.

It's a pretty old cliche, but the, I think banks really need to differentiate themselves on cost at this point. I think the trying to get back to the old days of 50 to one leverage just isn't going to happen. So that's not going to be the way of boosting return on equity going forward. It's got to be a leaner operation. All right. Barry, last question. When you go back and look at this report, which does seem fairly prescient five years later, are you proud of what you've done? Are you happy? Do you feel frustration that some of these eventualities are actually playing out in the market, though there were warnings about them, how do you actually feel about it now?

Yeah, well, I think the last line in the report was that the, you know, the crisis are not avoidable. We call it an avoidable history, but the reality is crises are not avoidable. You basically will get, you know, a business cycle continuing forever and we'll see financial crisis every, you know, five or ten years. I think what we, what I would be proud of would be if I'd helped any banks avoid being the victims of the crisis or whether we'd helped, you know, regulators better prepare for the crisis this time around. And, you know, we will see the result of that, you know, this time as effectively what I'm seeing is a real stress test where there's an emerging markets crisis and we're seeing,

we will see, you know, who withstands that well. And I guess the regulators that have helped their banks prepare well and recapitalize, we'll see that those banks weather them quite well. and the ones that haven't, you know, may see some problems. So, you know, as I was mentioned, I think, you know, it wasn't popular with the commodities traders, and I think a lot of banks withdrew quite heavily out of commodities over the last few years, you know, prior to the product price. So hopefully there have been some aspects of us helping, you know, banks avoid some of the losses that would otherwise be happening now. So, yeah, I guess I'm happy with the results.

But, you know, as I said, we haven't seen this. play out yet, so it'll be interesting to see who the winners and losers are in the actual crisis that happens down. All right, on that cheerful note, Barry, thank you so much. Thanks, guys. Cheers. All right, Luke, well, I have a feeling that Joe's going to be mad at us for going really wonky in that discussion, but I enjoyed it. I found it really interesting.

What did you think? I mean, I certainly did, too. One thing that would have been nice to get to was Barry was really worried about the treatment of sovereigns. know, there's a certain point to be made that financial crises, and especially the last one, it's a product of banks having a lot of assets on their balance sheet that they think are safe, but aren't. And he predicted that kind of the HQLA, those kind of moves, would eventually end up in the same thing

with highly indebted Western nations being forced to restructure. And right now, the market's saying that that's just not the case. Markets is very willing to lend forever to, you know, anyone with a printing. press and even European nations that don't have them. Right. So instead of seeing a sovereign debt crisis, if anything, we've seen almost the opposite, especially as markets have sold off recently. Exactly. I guess the other thing that I was thinking, you know, I don't want listeners to come away

thinking that consultancies are always geniuses. We've seen Oliver Wyman make poorer recommendations before. For instance, telling UBS to go all in fixed income in 2007. And that wasn't such a great recommendation. But I think when people talk about this kind of stuff five years before it happens, it does deserve some attention. So I liked hearing about the reaction to the report in Davos, how people felt about it at the time. The idea that commodities trainers were upset is kind of amusing now. I didn't like to hear the idea that he thinks, you know, it's just a matter of time before this plays out.

That doesn't exactly paint a great picture of what. hope we're in for and what we'll be writing about in 2020. No, that's very true. Well, I think we should wrap it up. Thank you, Luke, for joining me today. My pleasure. Hope I filled the shoes. This is another episode of Oddlots.

Tune in next week for another one, potentially less geeky than this one. Joe should be back by then. I'm Tracy Allaway, executive editor at Bloomberg Markets. You can catch me on Twitter at Tracy Allaway. And I'm Luke Cowell, reporter at Bloomberg Markets. You can also catch me on Twitter at LJ Kawa. Podcast Oddlots, but we are also very proud of Bloomberg's other growing suite of original podcast, all designed to help you navigate the complexities of business, financial markets, and the global economy.

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