Interview with Theo Vermaelen - The future of finance

May 2013

Theo Vermaelen is Program Advisor at Amsterdam Institute of Finance, and Schroders Chaired Professor of International Finance and Asset Management at INSEAD where he teaches in MBA, PhD and Executive Programs.


How do you see the future of Finance?
Well, the stock market is usually a very good predictor of the future. Based on that the future of finance looks bright as European bank stocks have increased by 50 % during the last year. This, in spite of all the revengeful populist measures coming from European politicians such as the financial transactions tax and limits on bankers bonuses. This revengeful attitude is difficult to understand considering that many governments have actually made money thanks to the bailouts. For example, the largest investor in Fortis-BNP is the Belgian government and they look more and more like Warren Buffett: investors with deep pockets who were able to buy distressed securities at bargain prices.


Aren't these measures necessary to correct abuses of the past such as excessive risk taking and speculation?
Limiting bankers bonuses to 100 % of salaries will not reduce risk taking as banks simply will increase fixed salaries. This will increase the operating leverage of the bank, i.e. the ratio of fixed to variable costs, and makes banks more risky.  Bonuses are variable pay, they allow risk sharing between employees and shareholders, something that seems to be largely ignored in this debate. The financial transaction tax is another dumb idea, unfortunately agreed already agreed by 11 EU countries. It was tried out in Sweden in 1982 and it killed the derivatives and bond market. A large fraction of Swedish equity trading moved to London.  Politicians are trying to prevent this migration by tying the transaction cost to the headquarters of the traded security. So if you trade a French stock in New York you would still have to pay. The net effect of all of this is that liquidity of European stocks will decline, increasing the cost of capital and thereby undermining European competitiveness.


How will Bank capital regulation affect the future of finance ?
Unfortunately regulators don't have learned a lot from the past. They still hang on to risk-weighted capital ratios the major tool for bank regulation. This in spite of the overwhelming evidence that these ratios have zero predictive capacity when forecasting financial distress. For example Dexia had great capital ratios the day  before it went belly up and it was ranked in the top 15 % during the stress tests a few months earlier. The problem with the ratio is that the numerator is book value of equity, which is based on accounting information and therefore not forward looking. The problem with the denominator is that it can be manipulated by changing the risk of the assets just prior to the reporting of the ratio.  It also discourages banks from risky lending to small and medium companies, even if this risk is compensated by higher expected return ( a variable not measured by the ratio).  This discourages economic growth as it cuts off debt financing to small and medium enterprises who don't have access to the bond market.


So what regulatory improvements would you suggest?
Well as you know I am a big fan of cocobonds with market based triggers. A cocobond forces the bondholder to become a shareholder if the bank gets in financial distress. It makes it clear to everyone that you won't be bailed out by the government. In that case you avoid situations such as the case of SNS bank were subordinated debt holders were not bailed out, against expectations. Or the larger depositors in Cyprus who had to write down their deposits in return for bank shares.  The problem with these arbitrary decisions is that now every bondholder or large depositor has to guess what the government is going to do when the bank gets into trouble. With a cocobond this implicit contract is replaced with an explicit one which makes it clear to all parties what the consequences will be. Unfortunately regulators seem to be obsessed with micromanaging the design of the securities, in particular requiring that triggers are based on capital ratios. The crisis taught us that these triggers would not have led to conversions as capital ratios remained stale.


And what about the future of financial education?
I see an increased demand for training in private banking, now that the clients are asked directly to pay for advice, rather than indirectly through commissions on products.  This means that bankers have to become more knowledgeable about portfolio management, derivatives and even corporate finance as the clients with the highest potential are wealthy people who also are running their own company. Because these companies are small, it is difficult to get investment bankers interested in spending time with them. Hence private bankers who per definition are interested in a long term relationship, should have a strong incentive to better understand the businesses of their clients.

May 2013