The world’s new financial brokers Based on the article by Diana Farrell, Susan Lund McKinsey Quarterly, 2008 Number 1 By A.V. Vedpuriswar

Introduction  Distribution of wealth around the world is changing.  Financial power was earlier concentrated in the developed world.  Now it is dispersing to oil rich countries and central banks in east and south east Asia.  Hedge funds and private equity investors have become important players.  Assets of these players have tripled since 2000 to reach $8.5 trillion (end of 2006). Or 5% of the total global financial assets of $ 167 trillion

Impact  US interest rates have been kept low because of higher liquidity.  Investments in emerging markets are increasing.  There has been a significant growth of credit derivatives and other risk transfer mechanisms.  There has been a positive impact on corporate governance through leveraged takeovers and subsequent restructuring.

Oil exporting countries  Indonesia, Middle East, Nigeria, Norway, Russia, Venezuela.  Sovereign wealth funds, government investment companies, state owned enterprises, wealthy individuals are the main players.  In 2006, about $200 billion of petrodollars went into global equity markets, $100 billion into global fixed income markets and $40 billion into global hedge funds, private equity firms and other alternative investments.  GCC states (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and UAE) had foreign assets in the range $ trillion by the end of  At the end of 2006, oil exporters collectively owned $3.4 - $3.8 trillion of foreign financial assets.

Sovereign Wealth Funds Fund Asset ($ billion)  Abu Dhabi Investment Authority875  Norway Government Pension Fund300  Russia Oil Stabilisation Fund100  Kuwait Investment Authority200

Asian Central Banks  In 2006, they held $3.1 trillion in foreign reserve assets, three times the amount in  China’s reserves alone were $1.4 trillion in mid  This money has mostly gone into conservative investments such as US treasury bills.  Opportunity cost of not investing in higher yielding instruments has been estimated at $100 billion.  Some of these reserves are now being channeled into sovereign wealth funds.

Hedge Funds  Assets under management by hedge funds reached $1.7 trillion by the middle of 2007  Oil investors are big clients of hedge funds.  In 2006, hedge funds accounted for 30-60% of trading volumes in the US equity and debt markets  In higher risk asset classes such as derivatives and distressed debt, they are the largest player.  Hedge funds are also big players in credit derivative markets.  Ten years ago, their investments were mostly directional bets on macro economic indicators.  Now arbitrage and market neutral strategies have become more common.

Private Equity  Assets under management rose 2.5 times to $710 billion during the period  Private Equity (PE) industry is roughly half the size of hedge funds.  PE funds have 4-5 year investment horizons.  They have concentrated ownership positions.  Resulting in more effective restructuring efforts.  P E Investors accounted for one third of all US M&A in 2006 and nearly 20% in Europe.  For the past 25 years, financial intermediation has moved away from bank lending to capital markets.  The rise of private equity and private pools of capital in sovereign wealth funds herald the resurgence of private forms of financing.

Conclusion  The importance of oil exporting countries, Asian central banks, hedge funds and private equity will continue to increase.  More transparency will be expected from sovereign wealth funds in the coming years.  Bankers must protect themselves against the risks posed by hedge funds and private equity funds.  They need tools and incentives to measure and monitor exposure effectively.  As institutions originate more and more loans without putting their own capital at risk for the long term performance of those loans, regulators should find ways to check a decline in standards.