Episode 12: How a Consultant Foresaw the 2015 Commodities Crash

Bloomberg Markets reporter and semi famous Canadian. Luke, we're both Davos rejects today, right, Yes, Tracy, they tend not to let riff raff like us in there. Yes, this is very sad. Well, on that note, look, I thought for this week's podcast it might be fun to go back to five Davos is ago, by which I mean two thousand eleven, when an analyst at a consultancy called Oliver Wyman published a report while at the meeting in Switzerland, and the report was called the Financial Crisis of two

thousand fifteen and Avoidable History. Oh what I miss? I don't think we had a banking crisis in we definitely didn't, and we're gonna 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 what my appetite a little give me a little sample of that? Hop Yeah, I've got the report right here. Um, bear in mind, once again, this is five years old. Now here's a 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 two thousand eleven 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, Berry, welcome to the show. Just give us a bit of background about who you are and what you do at Oliver Wyman. But I'm currently the co head of Oliver Wyman's Finance and respractice. So I

guess my specialty is risk managements. I've been working at the company twenty two years, so I got 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 a specialties around the trading risk management side of things as well. All right, So take us back to January two thousand eleven and you publish this report to coincide

with Dabos. 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, Um, you know, a large wave of work around you know CECR e B a e c B type stress testing. I actually have that background in you know, go back

to my university days. I used to be sitting in the lab building bridges testing stress testing heavy load latteral in you know, trying to twist twist the bridge and it basically boiled down to you know, could be could the bridge with with strand you know a certain level of stress. That was kind of what the whole points of the exposs was. And was there any special reason why you chose to release it at Davos. Yeah, well, I mean I guess, um, we we we write these

annual reports. You may have seen we just released another report more account around the fintech one this year. I think it was a you know, we're in the post crisis environment. The feeling I had at the time was, you know, there were still lessons to be learned from the from the previous crisis, and you know my sentiment was, you know, I being in risponagement for such a long cude. I've 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 thinking ahead. It's not about thinking about chances of being another crisis. 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 banning and quantifying, quantifying the impact of potential crisis. Can you take us back to two thousand eleven and for the uninitiated, just

you know, explain the basic thrust of your thesis. Yes, So, I mean, I guess I was trying to get across the idea of um, you know, so moving more towards you know, stress testing as a risk management philosophy. And then I I used a particular scenario as a way of bringing the whole topic for life. So I thought that I just you know, focused on the mechanics of

stress testing, it would have been acquired dry read. So I I wrote a virtual history which was basically laying out the scenario, taking us from two thousand eleven to two thousand and fifteen, where I was talking about, you know, the commodity price price bubble getting you further inflated by loose monetary policy coming from you know, the western central banks. Um, you know, the emerging markets countries, particularly the commodities producers,

feeling the benefit to that. And then at some point, you know, people realizing that the narrative around you know, China growing growing forever. Uh, you know, as China slowed, we'd see the whole bubble burst. And I guess the timing turned out to be quite um 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 two thousand eleven or 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 everyone. Actually, I mean I'd say there were two camps. So I give you two extreme examples. So, um, In one example, I had a risk manager in a bank, you know, coming with with her reports 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, the need to kind of point out potential risks, etcetera. At the other end of the spectrum, I hear in Um, you know, amongst commodity traders, people were talking about you know that

Bloody Wilkinson reports. So I think, you know that 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, of you know, death holders, whereas the front office are more aligned with the kind of shareholder interested in 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. You know, I guess pre crisis it was out of balance in the direction of short term upside. Post crisis, you might argue sometimes you know, the regulators are pulling it too far in the other direction. But you know that's that's I think that's a natural tension that needs to be explored. Well, let's talk about commodities for a second, because, as you've mentioned already, this is kind of um a

centerpiece of your report. And back in two thousand eleven, the commodity space was booming. I mean, I think we forget that now, but it was just going sort of game busters. Why did you decide to focus on the risks in the commodity space. Well, I think that's the whole point. You know, whenever you're looking at the next crisis,

you should be looking at the current bubble. When any time asset prices are rising a you know, a hundred percent per anum or you know, I think oil prices rose something like eight between you know, the low of seventeen up two hundred and twenty bowls about or whatever.

So you know, when you start seeing that kind of asset price appreciation, you know 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 as always you know a recipe for 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, a lots of rapid increases, so predicting the next prices. It's really looking at where people are making a lot of money. Now really it's obviously a very contrarian perspective, but it's there's no I think the idea of you know, there'll be no point focusing on the subprime market now as you're you know, just because that was the previous crisis, you'd always been looking at the

net the next bubble. So we've we've brought up the big thing that you really nailed in this report, that's the commodity's downturn and that 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 that's right. So I think we've got to the stage now wherey you know, China is sload. There is a talk of a crisis centered around you know, the mining companies, commodities

producing nations. As we said in the poor what what what we haven't seen or is a full blewn 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, that we haven't seen massive debt restructuring or or bad loans. So so from my from 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 their amount of financing

you know, behind that. And the next next step for me, I think is is to take it from macro level of 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 you know which banks are ultimately holding 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's um 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 were in every year. I think the emerging markets regulators, you know, 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, and looking at individual institutions and running running stress tests along the lines

of 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 shadow 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 is played out. I think it's quite difficult to buy back test, you know, some of the cooking of the specific things we said, because it's by its very nature, it's kind of lurking in the shadows, and as we saw with the previous round, of shadow banking, all these kind of siev light vehicles that were hidden off balance sheet. Not a lot of people know about these things until the crisis hits and then suddenly, you know,

bank has to reconsolidate this balance shee's activity. So there may well be a new phase of that where it could be the Chinese banks this time having to reconsolidate you know, all of these trusts back onto their balance sheet to you know, to save face or whatever. But um, yeah, it's very difficult to say where 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 that if you look at it's it's difficult to put numbers around it. But any any report you look at that you tend to see, you know, kind of growing shadow banking liabilities at the same time, So I suspect there's

there's quite a lot out there. So it's five years after you publish this report, have you been back to DAVERS since then? I haven't. We go there every year. It's usually the the author of of that year's report who who goes in attends alongside you know, a couple of our more senior guys. So, um, it's uh, I

haven't been back. I mean I have been thinking of doing a kind of you know, a victory lab and you report that you know I could do, but just more of a you know, you know what maybe next year is that some more more forward looking views on on risk management and finance and all that. So what are you looking at right now? What's next on the horizon? Yeah? Well, actually, as I said, I think, you know, looking back um on prior on the previous crisis is often not the

way to think. So if I'm it was looking at the financial service industry. Now, what we've been focusing on this in this new report is really that disruptive 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 you know, the cost structures of the banking system, and that could be equally you know, equally deadly for some of the banks if they're if they're not able to adapt that.

I think some of the things you mentioned in this year's report is more around, um, you know, it's actually the regulators are are actually helping the banks that create you know, barriers at barriers of entry for for new players. And if those barriers to entry were not there, you know, finances the ultimate commodity in many ways, so you know, it would all ultimately just be about who's got the best technology and the best cost cost structure to deliver

that commodity. Um. But at the moment, having access to the central bank, having access to deposit insurance just gives you know, banks a massive, a massive advantage that they will I think we'll preserve their positions for quite a while. Um. But I think at some point, you know, we've seen the payments part of things getting picked off. I think at some point different parts of the value chain will start to get eroded by these new players. I think

that's a big threat for the banks. Yeah. On that note, I mean I have to say we have seen at least one disruptive of fintech player, Lending Club, ask for access to central bank facilities, which would it's pretty amazing and would potentially put them on a more even footing with banking competitors exactly. W I mean one way, one direction you can take it is in the direction of I think the most difficult bit to disrupt is that

there is a 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 sayn into the Central Bank access you you obviously can then weather a few a few cycles and if you don't have access,

you can't. So we've been thinking about whether you could, you know, the central Bank could 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 lending then just becomes a commodity. And similarly, you know, investing in short term liabilities as another commodity. So you'd have kind of the

money market funds type part of the value chain. You'd have the pure lender, and then you'd have this money money market money transformation utility sitting in the center. So charity transformation comes back on the central bank anyway, you know, during the crisis that maybe they should be managing it in

in the first place. So it's just a certainly it's kind of a you know, utopian source of this poem, But I think that's where you need to get to if you really want to open up competition across you know, the you know, the the core products of banking. And to go back to two thousand eleven, 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 to investors treatment of banks and the

around the two thousand and eleven period. And I want to know, the market seem 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. Well, it's it's a lot more complicated now.

And I think in the days where you know, you could basically create ahold of value just by increasing leverage in your bank, um, you know, increasing leverages multiplies your return on assets by your leverage and creates return on equity. And then it was it was an actually and also that leverage also gives makes it look like you're growing as well, so you get all these massive p multiple.

In today's context, you have you know, regulators looking at you thinking that you're two leverage and then suddenly forcing you to raise capital, which it's never great for share prices.

So it's it's a lot more complicated. Um. I guess the you know, 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, but you know, outside of the purview of the regulators who are coming in and trying to climb 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 the shadow banking activities where you can actually take you know, take risk off outside the radar of the regulators. But you know again that that's a very short term as approach which will unravel at some point. So yeah, I mean, I think I think in general banks it's all about it's all about costs at this point. I think the risk

is generally a commodity. You know, you generally get paid for the risks risk. The more risk you take, more return you gets pretty old cliche, but the I think banks really need to differentiate themselves on costs at this point. I think the trying to get back to the old days of fifty two one leverage just isn't going to happen. So that's not going to be the way of boosting return and extually going forward. It's got to be, you know,

a leaner operation, alright, barrier. Last question, are you um when you go back and look at this report, which you know, does seem fairly prescient five years later, are you proud of what you've done? Are you happy? Or do you feel frustration that some of these eventualities are actually playing out in the market even though there were

warnings about them. How do you actually feel about it now? Yeah? Well, our I think the last line and the report was that the you know this, the crisis are not avoidable. We call it an avoidable his you, But the reality is crises are not avoidable. You basically will get you a business cycle continuing forever, and we'll we'll see financial

crisis every five or ten years. I think what we what I would be proud of would be if I had helped any any banks avoid being the victims of the of the crisis, or whether we've 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 when 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 recapitalized, we'll see that those banks whether the storm quite well are the ones that haven't you 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 prior to

the product quality crisis. So hopefully there have been some aspect of those helping you know, banks um avoid some of the losses that that that would wed otherwise be happening now. So yeah, I guess I'm happy with with the results. But you know, as I said, we haven't we haven't seen this play out yet, so it'll be interesting to see who the winners and losers are in

the actual, the actual crisis that happens now. All right, on that cheerful note, Barry, thank you so much, Thanks guys, Just all right, Luke, Well, I have a feeling that Joe is going to be mad at us for going really wonky in that discussion. But I enjoyed it. I found it really interesting. What do you think I mean, I certainly did to. One thing that would have been nice to get to was Barry was really worried about

the treatment of of sovereigns. And you know, there's a certain point to be made that financial crazies, and especially the last one, it's it's a product of banks having a lot of assets on their balance sheet that they think are safe but aren't so. And he predicted that kind of the the h q l A, that 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 markets saying that that's just not the case.

Market 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. UM. 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. Um. We've seen Oliver Wyman make poorer recommendations before, for instance, telling ubs to go all in fixed income in two thousand seven. 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 Commodo at these 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 we're in for and what we'll be writing about. No, that's very true. Well, I think we should wrap it up. Thank you Luke for joining me today. My pleasure, Hope I followed the shoes. This is another episode of odd Lots.

Tune in next week for another one, potentially less scheeky than this one. Joe should be back by then. I'm Tracy Alloway, Executive editor of Bloomberg Markets. You can catch me on Twitter at Tracy Alloway, and I'm Lukewa, reporter at Bloomberg Markets. You can also catch me on Twitter

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