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McKinsey & Company's Banking & Securities Practice
November, 2001
Contacts:
David Hunt, director
Raj Seshadri, principal
Alastair Cairns, associate principal
This report on the financial services sector is based on research and analysis carried out by McKinsey & Company. This chapter is organized into four sections:
 | | | | | Impact on Financial Services in New York City Answer |
| | | | Impact on Financial Markets Answer |
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| | | Executive Summary | | Forty percent, or 1,700, of the civilians killed in the attack on the World Trade Center worked in the financial services industry.
The immediate impact on economics of the industry was modest relative to the overall size of the financial services sector. Capital losses were limited, since most financial services firms rented space and have high levels of insurance coverage. While the industry suffered a shock due to the suspension of most trading for several days, financial systems performed well overall.
Looking forward, however, there is cause for concern, both for the industry and for the New York City economy, whose fortune is very dependent on financial services. Of the thousands of jobs that have temporarily left the city, many may never come back. In the short-term, this dislocation of employees will deprive the city of substantial tax revenue and will have ripple effects on the Lower Manhattan economy. In the longer term, the greater concern lies in retaining additional jobs that may leave over time, as companies place operations in multiple locations to achieve higher levels of security and to position themselves to activate alternative systems in the event of a manmade or natural disaster. Some smaller firms may leave entirely due to security concerns and desires to end difficult commutes for employees.
In addition, the attack exposed structural deficiencies in the financial system – lack of geographic diversity in back-up plans, insufficient access to back-up sites, a lack of alternative networks and systems for telecommunications and power, and a vulnerability to key "choke points." These weaknesses could pose a significant threat in the event of future system-wide disruptions.
This report offers recommendations for the city and the industry. New York City, assisted by the State and Federal governments, should regain the confidence of dislocated workers by: rapidly implementing a comprehensive security plan that minimizes additional disruptions; developing interim transportation solutions for key bottlenecks; and swiftly outlining a redevelopment plan for Lower Manhattan. Economic incentives may be used to influence certain relocation decisions, provided they are carefully tailored and structured. Over the longer term, public-private initiatives should be created to identify neighborhoods in the five boroughs where it makes business sense to develop back-up sites and, potentially, back-office operations.
The financial services industry, with oversight and support from regulators, should reduce the exposure of financial market participants to systemic vulnerabilities. Regulatory oversight of individual institutions, and the linkages among them, should provide guidance on alleviating operational risks. At the same time, the industry should develop an alternative communications network for use in emergency situations and should work collaboratively with the utilities to make the infrastructure as resilient as possible. | | | | | | Impact on Financial Services in New York City | | The financial services industry is a primary driver of the city economy, supporting substantial secondary employment and investment, and in turn, enhancing the city's prominence as a global business hub. In the near-term, primary concern of the public and private sectors should be the needs of dislocated employees, since they have a greater impact on the city's loss in output than industry-wide macro-economic effects. No government can mitigate the impact of the industry-wide slowdown in financial services. But City Hall, Albany and Washington can work together to restore Lower Manhattan as a desirable place to work and can fashion economic development tools that can maximize the number of dislocated employees who return. The long-term concern for New Yorkers and the city economy is the potentially greater loss that would flow from a broader group of at risk employees leaving the city.
Direct economic losses to the industry were modest
Of the $30 billion in total property damage, only about $4.4 billion was attributable to financial services firms, since most firms leased their office space. Moreover, with a majority of the property damage covered by insurance, the net loss to the sector will be even lower. The cost of business disruption, a combination of lost revenues due to market closure and dislocation expenses, was about $1.8 billion, and was partially covered by insurance. Although the aggregate losses were manageable, many individual financial services firms experienced a devastating loss of life and intellectual capital; some smaller firms located in the World Trade Center, such as Cantor Fitzgerald, were particularly hard hit.
Incremental layoffs will be low
The events of September 11 will only marginally accelerate employment losses in the financial services sector in New York. Over the past 10 years, New York City has gradually lost share of national financial services employment. Before September 11th, major NYC-based financial services firms had already announced over 30,000 layoffs globally, including an estimated 11,000 in the New York area. After September 11, over 13,000 global layoffs were announced, the majority of which would have occurred regardless. The attack and its aftermath are expected to result in another 2,400 layoffs in New York City in the fourth quarter.
Job dislocations will be significant
The World Trade Center disaster has dislocated more than 50,000 financial services employees from Lower Manhattan, of whom 19,000 have moved into office space outside of New York City, primarily in New Jersey. An estimated 7,000 of the 19,000 are unlikely to return to New York City. The total impact of dislocation will reduce wages earned in the city by $1.1 billion in the fourth quarter of 2001.
Longer-term challenge is to retain remaining employees
Interviews conducted for this economic impact study suggest that a far larger challenge for New York's public and private sector are firms that may transfer some or all of their employees out of the city. After dislocation, there remain about 272,000 people working for financial services firms in New York, with 129,000 of them based in Lower Manhattan. Without a thorough survey, developing a solid estimate of the size of the "at risk" pool of employees is not possible. A "back-of-the-envelope" calculation indicates that it may be as large as 31,000, including an estimated 6,000 employees from small firms that may move out of the city and an estimated 25,000 employees from large firms that may seek to diversify their operations in locations outside of the city.
Loss of jobs and employees is likely to have greater impact than industry-wide slowdown
The impact of the slowdown of the economy and of losing financial services workers in New York City will be felt directly through lower tax revenues and indirectly through ripple effects on other sectors of the city's economy, particularly in Lower Manhattan. The financial services sector, especially securities firms, was already experiencing a decline in revenues and profitability before the attack. Estimates based on analyst forecasts, prior to and after the attack, suggest that New York City's financial services sector will lose another $3.2 billion in economic output (i.e., the value-added of goods and services produced in the city) in the fourth quarter of 2001 due to further slowing of the economy that can be attributed to the attack on the World Trade Center. Through 2003, the total incremental loss of output due to macro-economic effects could be $4 billion to $10 billion, depending on the severity and length of the downturn in the broader economy. Clearly, the magnitude of the macro-economic effect is dependent on one's assessment of the impact of September 11 on financial services over the long term, and could be substantially greater than what has been assumed.
In the short-term, New York City should focus its attention on winning back dislocated employees since they account for a greater impact on output than macro-economic effects – additional losses of $7 billion to $11 billion through 2003, resulting in total losses of $11 billion to $21 billion when combined with macro-economic effects. Moreover, the city, state and federal governments are not in a position to exert any influence over the industry-wide contraction in financial services. But these governments can directly address this issue of winning back dislocated workers.
In the longer-term, losing the broader group more than 30,000 "at risk" employees should be the top priority for those in the public and private sector committed to revitalizing the central business district in Lower Manhattan. The magnitude of this potential exodus is significant – an additional $11 billion in annual output, were this entire group to leave New York. | | | | | | Impact on Financial Markets | | While the financial system experienced no major breakdowns as a result of the events of September 11, the attacks exposed significant deficiencies.
The system performed well – this time
Overall, the financial system held up remarkably well, given the extent of physical damage and disruption. But there were a few exceptions, which are outlined below:
Wholesale payments systems. There was major disruption to the clearing banks, which affected other markets (e.g., Treasury securities). As a whole, however, payments systems involving institutional transactions performed well, with continued operations from Manhattan or back-up sites.
Fixed income markets. As a result of the disruption to the clearing banks and damage to major inter-dealer brokers, market making and clearing in Treasury securities were suspended briefly. These effects spilled over from government securities trading to the repo market. The Federal Reserve correctly diagnosed this as a liquidity issue, not a credit issue, and pumped $80 billion of liquidity into the system to help avert a major market failure.
Corporate credit market. Due to overall uncertainty in the commercial paper market, some corporations sought to draw down their short-term lines of credit, especially commercial paper back-stops. In instances where some banks were unable to fund loans due to physical disruption, other banks stepped in to advance the entire amount to help avert larger-scale commercial paper defaults.
Commodities and foreign exchange markets. Some commodities markets were closed for four days due to damage to buildings, but trading resumed the following week. In foreign exchange markets, foreign banks were unable to borrow U.S. dollars from U.S. banks, causing the Federal Reserve to intervene and arrange for $90 billion in foreign swaps.
Equity markets. Restrictions on access to Lower Manhattan and connectivity problems between the exchanges and member firms/market-makers forced the equity markets to close for four days, although clearing and settlement were unaffected. Fortunately, the New York Stock Exchange and Nasdaq themselves were undamaged and trading resumed seamlessly when those exchanges reopened on September 17.
Retail payment systems. The Federal Reserve was unable to transfer paper checks between Fed districts due to the shutdown of civilian air traffic in the days following the attack. As a result, the Fed undertook some temporary credit risk by extending the float to banks. All other retail payments functioned normally throughout the period.
Some vulnerabilities were exposed
While individual companies dealt adequately with the business interruption caused by the attack, the events of September 11 revealed certain important vulnerabilities in the financial system as a whole:
Diversification. Companies' back-up plans generally failed to address the need for geographic diversity in back-up sites.
Access. Back-up plans did not take into consideration the importance of quick and seamless access to back-up sites and failed to assume that mobility and transportation could be disrupted.
Connectivity. The underlying connectivity of the telecommunications and power infrastructure was surprisingly fragile, with single points of failure (e.g., the Verizon central office at 140 West Street). Both the energy infrastructure and the telecommunications infrastructure lacked alternative networks that could be activated swiftly.
"Choke points". In retrospect, the financial markets were and continue to be exposed to a few critical and highly concentrated "choke points" - key hubs such as exchanges, clearing firms and inter-dealer brokers. Disruption at the choke points triggers significant spillover effects for the rest of the financial services system.
| | | | | | Recommendations | | Although New York City's economy and the financial services industry are inextricably linked, distinct priorities need to be set going forward. The public and private sectors should pool their efforts to win back dislocated financial services employees and retain those now here. This would help maintain New York's pre-eminence in financial services and would protect its tax base. Separately, the industry should build a resilient infrastructure. This will entail adapting regulatory oversight of contingency measures to account for the operational risks highlighted by the attacks, particularly for "choke points," creating alternative communications methods, and developing alternative networks and systems for the power and telecommunications infrastructures.
Return and retain workers
Securing the return of dislocated workers should be the near-term priority for two reasons. Their departure from the financial services sector based in New York is the largest driver of damage to the city's economy. And it is the only driver that government efforts can influence. At the same time, it is essential to acknowledge the reality of the post-September 11th world. Additional employees currently working in Lower Manhattan remain "at risk" of leaving. The public and private sectors have a responsibility to strive to retain the headquarters and operations of larger firms, as well as make New York attractive and hospitable for smaller firms.
While redeveloping Lower Manhattan should be a priority for City Hall, Albany, Washington and the business community as a whole, it may be less so for individual financial services firms. Interviews across a range of firms suggest that for security reasons, many large firms will seek to diversify a portion of their operations beyond Lower Manhattan and are thus unlikely to return all of their dislocated employees to the area.
In the immediate term, the first priority must be to make Lower Manhattan a more desirable place to work. In conjunction, economic incentives to displaced companies could be used to influence relocation decisions. To the extent that the various levels of government decide to offer economic incentives, these packages should be carefully tailored and structured. Over the longer term, the city should develop low cost areas in the five boroughs to attract emergency back-up services and, potentially, back-office functions for financial services firms.
Immediately restore Lower Manhattan as a desirable place to work. Financial services firms considering a return to Lower Manhattan suggested during interviews that they would be reluctant to commit until they see government address the following critical issues:
Develop and announce a comprehensive security plan that minimizes additional disruptions, particularly around buildings in the Wall Street area and Midtown that are symbols of Corporate America's economic prowess. Quickly implement interim solutions for disrupted local transportation, like the PATH terminal destroyed in the attack on the Trade Center. These setbacks disproportionately affect financial services employees. Develop and announce a redevelopment plan for Lower Manhattan that minimizes additional disruption to firms located there, and assures both dislocated and remaining firms access and mobility in Lower Manhattan.
Offer tailored incentives to lure firms back, where appropriate. To the extent that they are used, economic incentives need to be tailored for specific firms with higher-value jobs. These incentives should also be customized to complement a firm's desire to avoid concentrating all of its operations and intellectual capital in one small geographic area.
Incentive packages may be well suited to influence certain near-term relocation decisions, provided they follow several guidelines. These include focusing on "at risk" companies that account for the majority of dislocated employees least likely to return to New York City, and creating mechanisms to limit the ability of non-dislocated companies to demand similar packages. These packages should also link incentives to specific requirements over time, and should be developed and made available in the very near term in order to have the greatest influence on imminent relocation decisions. These packages should also be structured to aggressively seek to retain higher-value-added jobs, particularly positions most at risk of migrating, including positions held by traders and fund managers. For the long term, New York City should focus on retaining in Manhattan certain jobs that have a natural network in the city – and not necessarily on bringing back jobs for which Manhattan is not cost-competitive. Maintaining a critical mass of key functions (e.g., investment banking, sales and trading) and key institutions (e.g., New York Stock Exchange, corporate headquarters) will allow the city to continue attracting intellectual and financial capital - both foundations of its pre-eminence in financial services and necessary elements of a competitive global center. Financial services firms are unlikely to return all of their employees to Lower Manhattan given their new emphasis on geographic diversification. Government incentive packages should explicitly address, rather than fight, this concern by encouraging financial services firms to relocate some employees across the five boroughs and by offering to build necessary infrastructure on a case-by-case basis. City Hall should emphasize areas that are attractive to financial services firms in terms of cost, infrastructure and access. It should also exploit the business-district potential of Downtown Brooklyn, Long Island City and the Far West Side of Manhattan.
Longer term, respond to specific infrastructure needs. To maintain its attractiveness to financial services firms, the city should facilitate the development of an infrastructure that responds to firms' specific needs. In particular, public-private initiatives should be created to identify neighborhoods in the five boroughs where it makes business sense to develop emergency back-up services and, potentially, back-office functions. The city could make these areas attractive to financial services firms by ensuring that they are served by multiple power grids and telecom networks necessary for back-up sites.
Build a more resilient financial system
The financial services industry should focus on identifying systemic vulnerabilities and improving contingency measures of all financial markets participants:
Enhance regulatory oversight of individual institutions and linkages among institutions. The events of September 11 highlighted the financial system's vulnerability to operational risks within and among financial institutions. In the wake of the attacks, regulatory agencies are actively re-examining their approach to oversight, which should be adapted at both levels:
Business Recovery Plans ("BRPs") of individual institutions. When regulating BRPs on an individual firm level, regulatory agencies should emphasize issues of access and connectivity. Systemic linkages and dependencies. In parallel, the regulatory agencies should institute mandatory industry-wide "stress tests" to explicitly test linkages between institutions. For example, in the equity markets, regulators and/or industry groups (e.g., the Federal Reserve, SEC, Securities Industry Association) could sponsor joint connectivity tests between back-up systems of selected firms, key clearing utilities, and major customers. Other entities (potentially including the Treasury, Bond Market Association) could sponsor tests for the bond markets with particular focus on the clearing and settlement process.
Create a secure alternative system for key "choke points." A system-wide effort should be launched to:
Develop a "wiring diagram" for the industry and identify choke points. One option would be to form a private-sector task force led by a respected industry member and comprised of representatives from Treasury, Federal Reserve and SEC, as well as payments utilities and key wholesale and retail firms. Explore a higher level of contingency standards for choke points. In developing new guidelines for BRPs of individual institutions, regulatory agencies should explore establishing higher benchmarks for critical elements of the system. In this respect, the commercial paper and repo markets should be considered for greater oversight to curtail the level of uncertainty. Create contingency procedures to ensure that local authorities can coordinate with key financial services leaders in the event of emergencies. Measures could include providing local authorities with a list of critical employees/employers at choke points to ensure priority access to offices in the event of another wide area shutdown and creating a hotline to facilitate coordination.
Create an alternative industry communications network. The industry should consider developing a secure network for use in emergency situations that does not rely on the main telecommunications network, or on the mobility of participants (e.g., to reach back-up sites). In addition, it should leverage existing technology to maintain a dynamic, real-time industry contact list and establish jointly agreed-upon contingency procedures.
Use industry influence to upgrade infrastructure. While the destruction and disruption of elements of the telecommunications and power infrastructures in Lower Manhattan create an opportunity for upgrading, individual firms have limited leverage to effect this because there are no alternative suppliers of these services. Financial services firms located in Lower Manhattan should consider forming an industry consortium to work with key energy companies and telecommunications companies to develop alternative systems and to upgrade critical infrastructure.
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