Ratings

Standard & Poor's short- and long-term ratings reflect default risk in either the short or long term, respectively. The ratings are meant to take into account the cyclical nature of an industry and, thus, change only minimally, if at all, through the peaks and troughs of a typical business cycle. This philosophy is reflected in the stability of ratings through industry cycles.

For the securities firms, to rate through a cycle means that the ratings depend on particular judgments about a "normal" cycle and about markets, industry structure, and securities firms themselves. Where most other industries face fairly predictable cycles of falling volumes and gradual inventory adjustment, securities firms face cycles that often include both sharp declines in prices and decreasing business volumes. In addition, no two cycles in the securities industry are alike, and Standard & Poor's continuously reviews whether cyclical downturns trigger changes in markets, industry structure, or securities firms' adaptability that call into question industrywide ratings.

During the past two decades, the securities industry has faced many cyclical downturns, all of which are unique in terms of the specific cause and the duration. These downturns are not always coincident with economic recessions. In addition to the recession of 2001, which was ignited by the bursting of the equity bubble in 2000, cyclical challenges for the industry have included the sharp rise in interest rates in 1994 and the Russian default/LTCM crisis of 1998. While it is impossible to predict the shape of the next cycle, it is certain that cycles will occur and that they will be accompanied by illiquidity in some major markets.

Competition in the securities industry leads to pro-cyclical activity so that the seeds of the next downturn are sown during the upswing in the cycle. Efforts to continue profit growth in good times result in greater risk-taking through ever larger positions, exotic structures, new geographic exposures, and a general loosening of credit terms. Regulatory compliance can also suffer during times when the industry is highly profitable. External events often trigger a topping out of a cycle and inexorably leave some participants exposed in unwanted positions and overextended cost bases. Liquidity may disappear in certain markets and price correlations can change rapidly, making once reliable hedges completely ineffective.

Through a downturn in securities markets, firms in the industry often retrench, cutting costs and restructuring business lines. Firms with a high degree of business line diversification and/or a focus on less-volatile activities tend to fare best through a downturn. Generally, however, there are large swings in profitability for the industry through a cycle.

It is because of the higher variability of performance through a business cycle that ratings on securities firms, in general, tend to be lower than those on the strongest commercial banks, especially for those banks that have high proportions of stable revenue sources.

Securities firms have ridden a wave of change in the capital markets. Change has been spurred by technology, disintermediation, demographics, and regulation. The consequence of external and internal change has been the growth in the number and size of competitors. As the capital markets around the world continue to develop, the need for capital size becomes more acute. At the same time, European universal banks are putting more capital into their capital markets activities. Additionally, U.S. commercial banks have encroached on the traditional turf of U.S. Securities firms and have gained market share in underwriting and M&A advisory. Competitive pressures from European and U.S. banks have resulted in overcapacity in the securities industry and declining margins.

Change has also engendered the globalization of capital markets. Given the increasing technological capabilities of moving money and information across borders, intermediaries need to be able to serve the cross-border demands of issuers and investors. The global infrastructure increases fixed expenses, but successful global penetration should lead to greater diversification and more stable revenues. There are increased risks that many different markets will fall in tandem in the short term, but the major individual markets will usually return to normal trading volumes to the degree that economic and monetary fundamentals are sound.

As securities markets evolve to more efficiently allocate risks, securities firms lead the way with complex new products. Over the past decade we have seen a sharp rise in risk management products, which also have the downside of potentially producing large unexpected losses for the uninitiated. Securities firms manage their risks from products such as derivatives with increasing sophistication. However, at the same time, the "edge of the envelope" is constantly being pushed out. Managing product complexity will always be a challenge in the securities business because the highest returns, at least on an ex ante basis, are earned on products with risks that are difficult to price and to manage.

The pressure to continually increase EPS, especially when it is generally felt that markets are in a recovery phase, can result in new products being introduced without sufficient knowledge of their risks. A marginal player may see a quick avenue to increasing earnings in expansion into products such as long-dated derivatives for which there is no opportunity to hedge without significant basis risk.

Global expansion, diversification into new lines of business (such as asset management, retail brokerage, and consumer lending), and evolving regulatory regimes also serve to dramatically increase the complexity of managing a large securities firm. The emphasis on avoiding unpleasant surprises should be on enterprise-wide risk management, which takes into account all of the risks that a firm faces. Only with a very strong risk management structure as well as a culture that promotes active risk management can a securities firm stay on top of the challenges of complexity.

Consolidation has occurred in waves in this industry. Consolidation in the early 1980s was based on emergent demand for capital market instruments, as well as the huge debt issuance of the U.S. government, both of which fueled growth of the over-the-counter markets and the need for trading capital. There was a jostling among competitors to acquire the necessary skills to become broader-based competitors. Consolidation has also accompanied cycles where initially weaker players fell into the hands of their competitors, as did E. F. Hutton. Internationally, consolidation was triggered by major policy changes, like the "Big Bang" in London.

In the mid-1990s, consolidation was triggered by regulatory change. The U.S. Federal Reserve Board decided to liberalize affiliation between commercial banks and securities firms. The move set off a scramble for both intra- and interindustry combinations. As commercial banks put additional capital into the securities markets, the increased competition will likely sustain continuing consolidation.

The good news for the consolidators is that securities firms' balance sheets are marked-to-market on a daily basis and are made up of readily salable positions for the most part. The bad news for consolidators is that buying an existing franchise is very risky, because by integrating a target firm, an acquirer can very easily lose many of the key people they need to keep.