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1 1 yasuyuki fuchita richard j. herring robert e. litan After the Crash: Will Finance Ever Be the Same? The financial crisis of 2007–08, which led to what is now known as the Great Recession of 2008–09, will go down in history as one of the most troubling economic events of the postwar era. Although some prescient analysts forecast that the housing bubble in the United States, which triggered the crisis, eventually would burst, we suspect that few foresaw the crisis bringing the United States and other global economies nearly to their knees. Certainly, no mainstream forecaster or high-profile policymaker predicted this outcome. Even now, after the dust has settled somewhat and a halting recovery is under way, many questions about the future of the global financial services industry remain. After receiving massive government infusions of capital and experiencing large numbers of failures, what will the U.S. commercial banking industry look like in the years ahead? Further, with only one major independent investment bank left in the United States after the crisis, what impact will new regulations have on the investment banking business, under whatever corporate structure it is conducted? The same question can be asked of the hedge fund industry, which went into the crisis largely unregulated. And finally, what is the evidence that the executive compensation structures of some financial companies contributed to the crisis (a criticism leveled by regulators and many in the media)? Should compensation regulation be imposed on the financial services industry? And if so, what form should it take? 01-0404-1 chap1 1 7/12/10 4:48 PM 2 yasuyuki fuchita, richard j. herring, and robert e. litan These are important questions not just for those who own shares in or work for financial services companies but also for the policymakers designing a regulatory framework and for concerned citizens, who fear another disruption of their lives, destruction of their wealth, and the fiscal consequences of government spending on cleaning up after such crises. It is appropriate, then, that these questions were also the subjects of a research conference jointly organized by the Nomura Institute of Capital Markets Research, the Brookings Institution, and the Wharton Financial Institutions Center in October 2009. This volume contains the revised presentations made at the conference, which came just one year after the worst of the crisis unfolded. During the third week in September 2008—after Lehman Brothers declared bankruptcy, after Merrill Lynch fled to safety in the arms of Bank of America, after the Federal Reserve improvised an unprecedented bailout of the creditors of AIG, and after the U.S. Treasury rushed to guarantee the more than $3 trillion held in U.S. money market funds—many observers believed the future of the financial services industry was utterly bleak. We provide in this introductory chapter a summary of the chapters that follow . A broad theme that runs through these chapters is that each of the segments of the financial services industry we review has been significantly affected by the crisis and is likely never to be the same again. Alan McIntyre and Michael Zeltkevic, of Oliver Wyman Group, focus in chapter 2 on the industry in which many of the problems first surfaced, the U.S. commercial banking industry, and examine its future. But first the authors briefly revisit the industry’s recent past, specifically what they call its golden era, the decade between 1993 and 2003. Cognizant of the savings and loan and banking crises of the previous decade, banks during the golden era recapitalized (at the direction of new legislation) and earned returns on equity of roughly 14 percent, the highest of any decade since the 1920s. The industry’s performance began to deteriorate in 2004, however, as the Federal Reserve reversed the loose money policy it had pursued in the wake of the 2000–01 recession. With a flatter yield curve, the spread between bank lending and deposit rates (upon which banks traditionally relied to earn most of their profits) narrowed. To cover their fixed costs, banks turned to asset growth, especially subprime and alt-A mortgage lending to make up the difference.1 Larger 1. Alt-A mortgages (alternative-A paper) are considered riskier than prime mortgages (A paper), because borrowers have less than full documentation, lower credit scores, higher loan-to-value ratios, or more investment properties than prime borrowers. Alt-A mortgages, however, are considered safer than subprime mortgages. 01-0404-1 chap1 2 7/12/10...

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