Dangerous MarketsMcKinseyl

Dangerous Markets: Managing in Financial Crises : 

Dangerous Markets: Managing in Financial Crises 2003 Annual Meeting of the World Economic Forum Davos, Switzerland January 24, 2003 This report is solely for the use of client personnel. No part of it may be circulated, quoted, or reproduced for distribution outside the client organization without prior written approval from McKinsey & Company. This material was used by McKinsey & Company during an oral presentation; it is not a complete record of the discussion.

OVERVIEW : 

OVERVIEW

INCREASING VOLATILITY AND INCIDENCE OF CRISES – THE GLOBAL ECONOMY IS IN TRANSITION: 

INCREASING VOLATILITY AND INCIDENCE OF CRISES – THE GLOBAL ECONOMY IS IN TRANSITION High barriers to interaction Fragmented, local market and industry structures Relatively self-contained national economies Relatively self-contained social/political tension More decision makers – billions of individual decisions by consumers, laborers, producers, and investors Faster transaction/response times (e.g., technology, media) More interconnected/linked world (e.g., interest rates, stock indices) Liberalization Mobility of capital Digital world Global forces at work Common standards

THE FINANCIAL STOCK OUTSTANDING HAS MORE THAN DOUBLED OVER THE LAST DECADE: 

Distribution of financial stock outstanding,* US$ billions * Developed world only Source: IMF; Salomon Brothers; IFC; BVIM; Baring Brothers; ISDA; McKinsey analysis 4,815 11,360 1,420 4,750 8,875 27,220 7,930 2,782 10,295 22,000 17,400 214 1,926 3,550 963 1980 1992 2000 100% = $10,700 35,500 79,300 Elements of financial stock Corporate bonds Government bonds International bonds Money supply Equities THE FINANCIAL STOCK OUTSTANDING HAS MORE THAN DOUBLED OVER THE LAST DECADE

SYSTEMIC CRISES INCREASINGLY FREQUENT: 

1980s SYSTEMIC CRISES INCREASINGLY FREQUENT Number of systemic crises Source: World Bank; McKinsey analysis 1990s 45 93 Growth rate 107% Does not include post- 2000 crises Turkey Argentina Uruguay Also does not include significant “brewing” problems Brazil Japan China India

GLOBALIZATION HAS SHIFTED POWER FROM GOVERNMENTS TO MARKETS: 

GLOBALIZATION HAS SHIFTED POWER FROM GOVERNMENTS TO MARKETS US$ billions Source: Central banks; IMF; McKinsey analysis Average daily FX turnover in New York, London, Tokyo Combined central bank foreign exchange reserves in US, UK, Japan, Germany, Switzerland 1983 1986 1992 1995 2000 Governments no longer possess the reserves to materially affect the global capital markets

GEO-POLITICAL VOLATILITY ON THE RISE : 

GEO-POLITICAL VOLATILITY ON THE RISE Trends Number of conflicts Significant change in the balance of world power (e.g., Russia, China) Growing gap between developed and developing countries Growing global threat by terrorists Source: www.hiif.de; Sigma; Swiss Re; McKinsey analysis 1992 Mainly violent conflicts (e.g., military force) 94 96 98 00 2002 Mainly non-violent conflicts (e.g., economic sanctions)

TURBULENT TIMES – THE VOLATILITY OF CAPITAL MARKETS IS A GOOD INDICATOR OF THE TURBULENCE IN TODAY’S ECONOMY: 

TURBULENT TIMES – THE VOLATILITY OF CAPITAL MARKETS IS A GOOD INDICATOR OF THE TURBULENCE IN TODAY’S ECONOMY Source: Compustat; McKinsey analysis S&P 500 Index: high, low, average, 1980-2002 Index price level 1980 82 84 86 88 90 92 94 96 98 00 2002

ADVANCED PREPARATION IS REQUIRED: 

ADVANCED PREPARATION IS REQUIRED 1. Keep an eye on the warning signs 2. Conserve cash and restructure debt 3. Minimize and prepare for customer/operational/supplier risks 4. Conduct scenario planning 5. Prepare crisis leadership Source: Barton, Newell, and Wilson, Dangerous Markets: Managing in Financial Crises (New York, Wiley Finance) 2002

10 KEY INDICATORS MANAGERS SHOULD MONITOR TO SEE THE WARNING SIGNS OF A CRISIS: 

10 KEY INDICATORS MANAGERS SHOULD MONITOR TO SEE THE WARNING SIGNS OF A CRISIS Value destruction by private sector (ROIC < WACC) Interest coverage ratio (ICR <2) Profitability of banks (ROA <1) Rapid growth in the lending portfolio Shifting deposits or rapidly rising deposit rates Nonperforming loans (>5% of total bank assets) Growth and term structure of loans from foreign banks Asset price bubbles (several years of 20% or more annual growth in asset prices) Government deficit as percentage of GDP Overvalued exchange rate

MANY COMPANIES THRIVE IN VOLATILITY AND CRISES: 

MANY COMPANIES THRIVE IN VOLATILITY AND CRISES Emerging markets Alfa Bank – Russia Banco Itaú – Brazil Banca Serfín – Mexico BCA – Indonesia Kookmin Bank (H&CB) – Korea Roust/Russian Standard Bank – Russia Thai Farmers Bank – Thailand Alarko – Turkey Astra – Indonesia Aurrera – Mexico Ayala Group – Philippines Doosan – Korea Hyundai Motors – Korea Samsung Electronics – Korea Ramayana – Indonesia Carlos Slim – Mexico Developed markets Christiana Bank – Norway Citibank Asia – Indonesia NationsBank (BankAmerica) – U.S. Mellon Bank – U.S. Coca-Cola – U.S. Emerson – U.S. GE Capital – U.S. Holcim – Switzerland Interbrew – Belgium Lonestar Fund – U.S. Newbridge Capital – U.S. Renault – France Shell – UK/NL Unilever – UK Banks Corporates Source: Barton, Newell, and Wilson, Dangerous Markets: Managing in Financial Crises (New York, Wiley Finance) 2002

NEW DEGREES OF FREEDOM IN CRISIS MUST BE EXPLORED: 

NEW DEGREES OF FREEDOM IN CRISIS MUST BE EXPLORED 5 degrees of freedom Source: Barton, Newell, and Wilson, Dangerous Markets: Managing in Financial Crises (New York, Wiley Finance) 2002

KEY ISSUES FOR MONDAY MORNING: 

KEY ISSUES FOR MONDAY MORNING 1. Do you have an early warning system in place that identifies the second- and third- order effects of turbulence in other markets (e.g., Japan)? Source: Barton, Newell, and Wilson, Dangerous Markets: Managing in Financial Crises (New York, Wiley Finance) 2002 2. Have you quantified the potential impact of the various risks? Financial Operational/supplier Customer/demand Strategic Regulatory 3. Do you understand the potential new degrees of freedom that arise from volatility and how to “seize the moment”? Competitive landscape Regulatory changes Customer behavior changes Organizational capacity for change Social values 4. Do you have the management systems (e.g., scenario planning) in place and organization action plans to manage the risks and capture new opportunities and options?

THERE ARE STORM CLOUDS ON THE HORIZON: 

High risk THERE ARE STORM CLOUDS ON THE HORIZON Source: Bloomberg; Japanese Banker’s Association; Bank of Japan Financial and Economic Statistics; Japan Economic Institute; Monetary and Economic Studies; Asian Wall Street Journal; EIU; Global Insight; Overseas Young Chinese Forum; Almanac of China's Finance and Banking; China's Statistical Yearbook; China Securities and Futures Statistical; Chinese Financial Institution Statistics; Bankscope; Bundesbank; IMF Statistics; Statistisches Bundesamt; McKinsey analysis and experience WORK IN PROGRESS Moderate risk Low risk Warning sign (criteria) Value destruction in the real sector Interest coverage ratio Profitability of banks Rapid growth in lending portfolio Shifting deposits or rapidly rising deposit rates Nonperforming loans Interbank, money market borrowing rates Asset bubbles Gov’t debt as percentage of GDP Overvalued FX rate China Japan ~70% of listed companies in SH and SZ had ROIC<WACC over last 5 yrs ~33% of companies with ICR<2, ~22% with ICR<1 over last 5 yrs Banking sector ROA <1% since 1994; at 0.37% in 2001 Growth rate decreasing steadily from 20% in 1994 to –1% in 2001 Majority of state-owned bank liabilities come from easily shifting retail deposits (high savings rates 39%) NPL/asset rate is estimated to currently be 40-50% (total NPLs estimated to be U.S.$480-604 billion) Overnight rate exceeded risk-free rate for 10 nonconsecutive months from 7/00 to 6/02 Real estate bubbles in Shanghai and Beijing Public sector debt reached 139% of GDP in 2002 RMB considered undervalued >30% of companies listed on Japan’s stock exchanges had ROIC<WACC over last 5 yrs ~20% of companies with ICR<2, ~13% with ICR<1 over last 5 yrs Banking sector ROA ≤ 0% for 5 of last 7 yrs; highest annual ROA since 1995; 0.31% in 1999 Total loans shrinking at an avg of 4% annually since 1997 Depositors shifted funds to cash, gold, or foreign assets after gov’t establishment of limited deposit guarantees NPL/assets ratio is estimated to be >20% in 2001 (total NPLs estimated to be U.S.$1.2-1.3 trillion) 10-yr gov’t bond index has exceeded the overnight interbank rate since Mar 1992 Equity and real estate bubbles burst in 1989 & 1990; deflation since then has kept prices low Public debt averaged 123% of GDP from 1999 to 2001 Yen considered overvalued Germany Estimates in Germany suggest that over last 5 yrs ~45% had ROIC<WACC Over last 5 yrs, ~33% with ICR<2, ~24% with ICR<1 Banking sector ROA, at ~0.3% for last 8 years; drops to 0.07% in 2001 Loan portfolio growth rate at 6.1% CAGR over last 10 yrs Deposits have risen in last 2 yrs; rates falling since 2000Q4 NPL/asset rate >2% for major banks in 2001 Overnight rate greater than 10-yr. gov’t bond rate from 9/00 to 8/01 (has since fallen) Real estate bubble in mid1990s; stock market crash in 2001 Public debt averaged 31% of GDP from 1999 to 2001 Euro valuation still unclear

PRIVATE FINANCIAL SECTOR MARKET POWER OVERWHELMS OFFICIAL MULTILATERAL LENDERS: 

Market investors 2001 Buy & hold (pension funds, insurance companies) 100% = US$35 trillion Buy & hold (mutual funds) Dynamic investors (hedge funds, proprietary trading desks) 66.0 32.6 1.4 100% = US$296 billion 2001 20.6 79.4 World Bank (IBRD, IDA) IMF credit outstanding Official lenders PRIVATE FINANCIAL SECTOR MARKET POWER OVERWHELMS OFFICIAL MULTILATERAL LENDERS Source: ING Group; IMF; World Bank; Barton, Newell, and Wilson, Dangerous Markets: Managing in Financial Crises (New York, Wiley Finance) 2002

THE PRIVATE SECTOR MUST STEP UP ITS ACTIONS FOR NEW MARKET STANDARDS AND SAFEGUARDS : 

Tier 2 Tier 3 Self-governance Corporate governance Accounting and auditing Transparency Choice of contract law Market supervision Capital markets, including pension funds Effective market for corporate control Rating agencies, credit bureaus Free press Government regulation Financial regulation Prudential supervision Legal reforms Tier 1 THE PRIVATE SECTOR MUST STEP UP ITS ACTIONS FOR NEW MARKET STANDARDS AND SAFEGUARDS 3-tier safety net Source: Barton, Newell, and Wilson, Dangerous Markets: Managing in Financial Crises (New York, Wiley Finance) 2002

INVESTORS AND INTERMEDIARIES CAN BE THE LEADING PLAYERS IN THE NEW FINANCIAL SYSTEM SGO: 

INVESTORS AND INTERMEDIARIES CAN BE THE LEADING PLAYERS IN THE NEW FINANCIAL SYSTEM SGO Mandate Agree on market standards and systemic safeguards for market conduct, risk management, customer protection Self-governance Market supervision Government regulation Monitor company performance and work for transparency in all markets on a timely basis Encourage market incentives as well as market penalties (e.g., cost of capital) Structure New global SGO Investors Intermediaries International Corporate Governance Network (ICGN) Institute of International Finance (IIF) e-Standards Forum, Moody’s, Standard & Poor’s Source: Barton, Newell, and Wilson, Dangerous Markets: Managing in Financial Crises (New York, Wiley Finance) 2002

OVERVIEW : 

OVERVIEW