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Understanding Banking Industry Basics

Robert B. Albertson
Vice President, u.s. Banking Research
Goldman, Sachs & Company

Decisions about investing in banking stocks should be made in the context of the recent
history of bank performance, the cyclical drivers of bank stocks, and the structural
challenges-including consolidation-the industry faces.

People have a great many misconceptions about


banks and banking. For example, consider the following simple, reasonable-sounding propositions:
III Bank capital ratios have deteriorated
during the past decade.
III Banks have been displaced from corporate lending by other forms of finance.
III Consumer debt is increasing and is
threatening profitability in banking because of high loan losses.
III Consolidation is the new wave, but
mergers must be done primarily in a
market with a lot of branch overlap to
make them work well.
III Bank earnings do not foretell what stock
prices are really going to do.
III Bank stocks are interest rate sensitive.
At the risk of oversimplification, all of these beliefs are largely wrong! I will discuss some of them
and present a broader view of three topics in the
banking industry: the recent history of bank performance; the cyclical drivers of bank stocks; and the
structural challenges the industry faces-basically
consolidation.

Recent History of Banking


The recent history of banking is rather straightforward. There are only three dates to remember: In
1978, interest rate deregulation got under way; in
1985, the Supreme Court said mergers were all right
but states had to approve them; and in 1990, the
famous BIS (Basle) ratio came together, leading everyone to decide they knew how to legislate the
correct capital ratio for banking. I will go through
these dates in order of importance, beginning with
the most recent.

Capital Ratios
The banking industry is probably the most leveraged industry in the country. Figure 1 traces almost 60 years of the equity-asset ratio for insured
commercial banks. The history of capital has been
quite dramatic. It has fallen a long way, but most of
the fall took place a long time ago. In the mid-1930s,
the equity-asset ratio exceeded 13 percent. Walter
Wriston was right: High capital ratios did not prevent carnage and failure. The ratio was even higher
before the Great Depression. It hit its recent nadir in
1979, and it has been in a slow but steady recovery
ever since.
The world conclave in 1990 that produced the
Basle Accord decided to look at assets in a more
sophisticated way. The assembled conferees provided guidelines that say the minimum capital ratio
should be 4 percent "Tier I," which is a euphemism
for common equity and some preferred. Most banks
in the United States are well above 4 percent, and
those that are not are very close to that level. Five
and one-half percent is actually the practical limit on
capital-that is to say, what is necessary to try to do
acquisitions.
Capital is probably the most important factor
explaining valuation differences in banking. Capital
is timeless. Capital collects the past, the present, and
the future. It cumulates past sins, reflects them in the
current condition of the bank, and tells what the
future opportunities are going to be for that bank. It
is more important than growth and profitability.
Figure 2 shows how value correlates with capital
levels in 1990 and October 1991. Although the R2
was 0 in 1980, and 0.38 in October 1991, it was as high
as 75 prior to the 1987 market crash. In recent years,
it has been the single most influential variable in
explaining price--earnings and price-book differ7

Figure 1. History of capital-Equity-Asset Ratio,


Insured Commercial Bank
14

Figure 2. Value Correlates to capital


150 , - - - - - - - - - - - - - - - - - - - - - ,

,--------------------~

140

13
~

12

:g

100

90

JlI

80

::: 10
OJ

9
8

.~

0::
l--...L--'--'----L---l_.l...-..L---L----L----L----.JL-L-...l...---l

S4S8~2~6~0~4~8~2~6'ro'~'~~~6~0

Source: Federal Deposit Insurance Corporation.

ences. Capital is the most powerful influence for four


simple reasons:
III Capital is a risk buffer, particularly in
bad times.
III A high capital ratio allows a bank to
recover from a recession faster and gain
in loan market share.
III Capital is an absolute prerequisite to
doing acquisitions. With increased consolidation in the industry, capital is
going to be more important.
III Capital will be a requirement for success
in a more liberal environment. It will be
the entry ticket to new products and
ventures if banks ever get enabling,
rather than punitive, legislation.

Interest Rate Deregulation


Interest rates are often thought to be an important factor in the valuation of bank stocks. Figure 3
compares movements in interest rates and bank
stock prices from 1972 to 1991. Interest rate deregulation began in 1978, causing quite a change in the
banking industry. At that point, money market deposits began to appear and consumer deposits began
to show significant interest rate sensitivity. Up until
then, interest rates on consumer deposits were fixed;
they were the anchor to windward for the banks. If
anything, banks did better in high-rate environments, as some asset yields were rate sensitive while
deposits were not, although they never went too far
out on that curve. In the late 1970s, interest rates on
consumer deposits became variable, causing the liability structure to change. In fact, to some people, the
liability structure was the tail wagging the dog. In
1981 came the big interest rate spike, and banks got
creamed on margin. They had to learn that lesson
8

70
60

..

...' . ..
.'
"

50
40 '-:----L:---L_..I....-----l_---L----.::.L.----.JL----L_....l------l
2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 7.5
Common Equity-Assets Ratio (%)
1990 Year End

120

~ 110

11

I-

1301-

230,----------------.---------,
220

~
o
'.g

200
180

160
~ 140
~

8 120

100

J, 100

;E

80
60

... .
.. ..
.
..
..
.
.-..
"

40
20 L-_---'--_ _L - _ - L_ _l.-_---L_ _.l...-_---.J
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
Common Equity-Assets Ratio (%)
October 1991
Source: Goldman, Sachs & Company

the hard way. Banks have always tried not to have


too much gap in their margins; they have always
tried not to be too interest rate sensitive.
Interest rates are not as powerful a predictor of
bank stock performance as some analysts think, however. The shaded areas in Figure 3 are the periods in
which our lOa-bank index outperformed the market.
During the periods where bank stocks outperformed
the market, interest rates were either rising, falling,
or indifferent.
Table 1 shows the results of a regression analysis
of the relationship between bank stock prices and
interest rates during the past two decades. The
upper portion is based on relative price performance
of bank stocks, and the lower portion is absolute
price performance. The independent variables are
short-term rates (the Federal funds rate), change in
short-term rates, long-term rates (la-year Treasuries), change in long-term rates, the yield curve proxy
(the yield on lO-year Treasury securities versus the
Federal funds rate), and the spread proxy (the prime
lending rate versus the cost of funds, or yield on
three-month certificates of deposit). The regressions

Figure 3. Stocks versus Rates--Relative Price Index, January 1972


January 1972 = 100
120

20

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~,

,~

19

w,

18

110

17
16
100

15
14
13
12

11

-;;;

Q)

10
9

~
~

en

Q)

2'"

70

7
6
60
5
4
50 ==~"""L~~...L..,~,.Lm....c,.JL"",~JL.".~,L, ...~.lwm.."""':td,UL.L~=...L.. ~====~~=~~--l~==~'
'72 '73 '74 '75 '76 '77 '78 '79 '80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91

Shaded areas represent periods of bank stock outperformance.

- - Relative Bank Price Index


- - - Federal Funds
. - - - - - 10-Year Treasuries
Source: Goldman, Sachs & Company

were estimated on a coincident, six-month lead and


six-month lag basis. In all cases, the R2s are virtually
zero. These stocks have very little consistent interest
rate sensitivity; although there are periodic relationships with short-term rates on an absolute basis,
none persevere.

Industry Structure
Banking has been the most discriminatedagainst industry in the United States. For the past 50
years, banks have been unable to modernize their
existing product, unable to broaden into other financial services, and unable to sell their archaic wares
except in very tight geographical areas. They have
been burdened with all sorts of community responsibilities. What banks have achieved in this environment is amazing. Think about any other industry or
stock and apply the same rules. For example, suppose Apple Computer could only sell its computers
in California. Suppose it could only sell its first-generation computer, one with a black and white screen

and less than 10 megabytes of memory. Suppose it


had to offer a discount to anyone over the age of 55.
What do you think would happen to Apple Computer?
Three kinds of diversity are important. Geography was a limitation for banks until the mid-1980s.
Then, some regional compacts were created, and a
lot of merger action took place in the Northeast and
Southeast. The first big one was Sun Trust, which
was a merger of equals. These regional compacts
were a step in the right direction, but more than
anything, they intensified concentration, albeit in
somewhat broader geography. Nevertheless, it still
kept most banks concentrated in one place; they
could not cross the country. The reason banks in
New England have been failing is because they were
only in New England, rather than in several regions.
Without this geographical restriction, the industry
could have avoided most of the Texas and New
England disasters, because the larger banks would
have diversified out of those regions.
9

Table 1. Regression Results, Bank Stock Prices on Interest Rates, 1972~1

Item

Change in
Treasuries at
Constant Maturity
ofIO Years

Federal
Funds
Rate

Change in
Federal Funds
Rate

Treasuries at
Constant Maturity
of 10 Years

0.00
-0.03
-0.11

0.01
1.39
1.39

0.00
0.38
1.00

0.00
-1.72
-0.79

0.01
5.14
1.50

0.05
-3.14
-3.56

0.00
-0.03
-0.13

0.00
0.20
0.20

0.00
-0.29
-0.76

0.01
-2.76
-1.27

0.01
-4.64
-1.36

0.07
-3.67
-4.29

0.00
0.08
0.32

0.00
0.31
0.34

0.02
-0.69
-1.94

0.00
-1.59
-0.79

0.08
-13.66
-4.28

0.13
-4.49
-5.80

0.01
-2.59
-1.83

0.00
-1.83
-0.34

0.00
1.00
0.49

0.02
-24.60
-2.10

0.01
20.79
1.12

0.04
15.23
3.19

0.02
-3.27
-2.37

0.00
-2.39
-0.45

0.00
-1.93
-0.95

0.01
-15.49
-1.33

0.00
8.21
0.45

0.03
13.52
2.89

0.03
-3.45
-2.42

0.00
-1.91
-0.35

0.01
-3.37
-1.62

0.00
-9.72
-0.83

0.00
-1.24
-0.06

0.01
8.22
1.72

Yield
Curve
Proxt

Spread
proxl

Relative bank stock index

R2
6-month lag

Coefficient
t-statistic

Coincident

Coefficient
t-statistic

R2

R2
6-month lead

Coefficient
t-statistic

Absolute bank stock index

R2
6-month lag

Coefficient
t-statistic

Coincident

Coefficient
t-statistic

R2

R2
6-month lead

Coefficient
t-statistic

Source: Goldman, Sachs & Company.


Note: R2 measures the success of the regression in predicting the values of the dependent variable. An R2 is 1.00 if the
regression fits perfectly, and 0.00 if it fits no better than the simple mean of the dependent variable. The coefficient measures
the contribution of its independent variable to the prediction. If the coefficient is zero or very small, the regression indicates
the variable is not helping the forecast. The t-statistic is the ratio of the regression coefficient to its standard error. If the
t-statistic is large, it is unlikely that the true value of the coefficient is actually zero. More specifically, if this value is greater
than 2, it is more than 95 percent likely that the coefficient is not zero. A t-statistic below 2 (in absolute terms) indicates the
variable is not considered significant and should be disregarded.
aRatio: yield on Treasuries at constant maturity of 10 years to Federal funds rate.
bSpread between prime lending rate and yield on three-month certificates of deposits.

The types of products offered by financial institutions in the 1980s is presented in Figure 4. Commercial banks competed in five products. In contrast, Sears, Transamerica, RCA, Gulf & Western, and
some of the others offered considerably more products. This provides a clear picture of the competition,
and it has been tough on bank product. Fleet Financial, one of the earliest to seriously diversify, said,
"We are the largest bank in the smallest state, so we
better do something." They got into nonbank subsidiaries that were near-banking, allowing them to
get a little bit outside of the product and geographic
restriction mold. Subsidiaries that are in mortgage
banking, asset-based commercial finance, and consumer finance are good ways around geographical
10

restrictions and should get some of the credit for


saving banks like Fleet and Norwest.
When banks finally hit on a solid earner, politicians invariably get upset: The credit card is an
amazing product. Everyone thinks banks are paying
off their losses on loans to less developed countries
with usurious rates to the consumer on their credit
cards. The average return on the credit card business
is 300 basis points pretax. The average yield is 18.9
percent per card. On an aftertax basis, this might be
150 basis point return, which I do not think is sinful
for the banks, but it makes banks into vulnerable
targets.
Loan portfolios. also pose diversification problems, although progress has been made, and banks

Figure 4. Product Possibilities Through the 1980s

Source: Citicorp.

have been much more disciplined. Actually, the


highly leveraged transaction business helped reduce
credit concentrations. In the mid-1970s, there was a
constant stream of big credits with problems, and the
banks seemed to always have big pieces of these
problems. Legal lending limits do not mean much
anymore; banks usually do not even get close to
them. In fact, loans retained on highly leveraged
transactions are typically about 0.5 percent of the
legal lending limit in many banks. This is one place
where lending limits have worked.
Lending limits have not worked in commercial
real estate. Unfortunately, that is the basic fundamental driver of the U.s. economy. Banks went from
18 to 22 percent of their assets in real estate. I find
that, in and of itself, not a bizarre number for an
entire loan category. I am stunned that we read little
in the newspapers about the real estate developers
who did the bad deals, compared to the banks that
lent to them. This is an industry that attracts an
enormous amount of criticism, which becomes progressively more unfair and unbalanced.

Cyclical Drivers
Banks have three cyclical drivers: credit demand,

interest rates, and loss cycles. These drivers are deceptively simple in theory but sometimes complex to
assemble.

Credit Demand
Credit demand is of two major types-eonsumer
and corporate. Banks always have a much sharper
loss cycle on the corporate side than on the consumer
side, primarily because consumers are debt maximizers and corporations are debt minimizers. For
debt maximizers, it is the Los Angeles freeway phenomenon: being so scared you drive carefully. The
minimizers-akin to "Sunday drivers"-only go
into debt when they have to, which is probably when
they should not: at the end of a recession or coming
into a recession. They get into trouble.
Consumer lending is very simple: Consumers
borrow based on strength of income. The appropriate debt level according to the average consumer is
as much as he can carry as long as he can service it.
Figure 5 shows consumer credit and disposable personal income growth during the past 15 years. They
track pretty well. In 1980, however, consumer credit
growth dropped like a rock. That was when President Carter was in office, and credit controls were
imposed. In 1984 and 1985, consumer credit took off
11

Figure 5. Consumer Credit OUtstanding versus


Disposable Personal Income

;::

....0
CJ

<e;:l
C
C

-<

22
20
18
16
14
12
10
8
6
4
2
0
-2
'76

Interest Rates

~,

'78

'80

'82

'84

'86

'88

'90 '91

- - Consumer Credit Outstanding


- - - Disposable Personal Income
OJ

E
0
u

20

..s

19

18

<ec

....C/l
OJ

P-.
OJ

17

:0

'"0

16

15

C/l

0-

'0

1::OJ 14
u
....
OJ

P-.

13
'76

'78

'80

'82

'84

'86

'88

'90 '91

Just as bank stock prices do not relate much to


interest rates, bank net interest margins are surprisingly stable as well. The upper panel in Figure 8
shows two mega-interest rate cycles, and the lower
panel shows bank margins. I do not see any powerful correlation between the interest rate cycle and the
bank margin cycle here, either. This is not an industry that bounces around from net interest margin.
The lower panel of Figure 8 also shows two
spreads: the prime rate versus money market account rates, and the prime rate versus the threemonth wholesale certificate of deposit rates. Basically, the prime to retail fund spread is coming down;
the other has been going up. Thus, we are basically
neutral on our margin outlook; the primary forces
should largely offset each other.
You hear about the Federal funds rate and the
discount rate going down a lot, while banks have not
dropped their lending rates. Banks do not use Fed
funds as a source of funds unless they have a serious
problem. Most of them are net placers, and the discount rate is a dirty word.
Figure 9 shows that the spread between the
prime rate and the Fed funds rate has been going up
during the past couple of years. The spread between
the prime rate and the true cost of funds has been flat,
however. Banks really just move their rates in line
with their true costs of funds. This is the proverbial
orange cart: They were paying whatever it costs to
buy the orange, and then selling it at a spread.

- - Consumer Credit
Source: Goldman, Sachs & Company.

like a rocket again as it became decontrolled. Basically, consumer borrowers will be back as soon as
their incomes come back.
Corporations borrow according to a simple algorithm that sums inventories plus spending minus
cash flow. This financing requirements "proxy" in
Figure 6 tracks very tightly with the growth in business loans. The statistics get treacherous in corporate
lending because we tend to focus business credit on
the Federal Reserve statistics on how much is outstanding in the banks.
Banks are more arrangers of credit than holders
of credit. (Many people still believe banks have been
replaced by commercial paper.) Figure 7 shows the
sum of all of the outstanding bank loans in all of the
corporate sectors in the United States-their liability
side-as a percent of total long-term debt. The percentage has actually gone up. If anything, I am concerned about the deleveraging phase we are facing
on the corporate side.
12

Loss Cycles
The loss cycle is the third cyclical driver. Figure
10 shows consumer loan losses for the past 60 years

Figure 6. Loans at Banks versus Financing


Requirements Proxy
30,-------------------,
25

20
15

2
CJ 10
';
;:l

c
c

-<

5
0
-5
-10
'76

'78

'80

'82

'84

'86

'88

- - Business Loans
- - - Financing Requirements Proxy
Source: Goldman, Sachs & Company.

'90 '91

Figure 7. Long-Tenn Bank Debt as a Percent of


Total Long-Tenn Debt

'i::
<J)

u
>-<
<J)

0...

33
32
31
30
29
28
27
26
25
24
23
22
21
73

75

77

'81

79

'83

'85

'87

'89

'91

Source: Goldman, Sachs & Company; Commerce Department,


Quarterly Financial Report.

FlQure 8. Average Rate Data Through OCtober 1991


Interest Rate Cycles
13r---,.,--------------------,
12
I~

11
10

'i::

I
I
I

<J)

u
>-<
<J)

0...

8
7

I
I
,,\

II

"

' I\

II' \
'-\ \
\/
,-

......

II

- -,

'-

I II
r/

'

I I

,\

\~

",

,-----'

-,

,
\

4'---_--'----_---'-_----'_ _.L......_--'--_--'-_--...J'---__
'84

'85

'86

'87

'88

'89

'90

using a consumer finance compact as proxy, and


Figure 11 shows all losses (consumer and corporate)
for the past 40 years. For consumers alone, the 1975
recession produced only a minor blip. During the
mid-1980s, the loss rates were actually declining
mostly because the mix changed; homeowner equity
loans and second mortgages replaced unsecured
lines. Consumer credit is also continuing to increase
in the overall mix, so the combination graph has an
upward bias. If that were removed, the corporate
loss cycle would show some pretty big swings.
Commercial losses are more volatile. The
charge-off ratio doubled in 1974 and again in 1982.
Commercial charge-offs bounce around. Consumer
losses are higher, but tamer. I believe for consumers
you do not need a loan loss reserve. Reserves are for
the unexpected; consumer losses are predictable.
I am frequently told that bank earnings do not
mean anything because no one trusts them. Figure
12 contradicts this belief, however. It shows earnings-per-share growth relative to the market against
bank stock price changes relative to the market. We
used core earnings, which are quarterly results adjusted to exclude nonrecurring events, such as the big
developing country provisions during 1987-89, and
other irregular items such as asset sales. The two
series have a much tighter fit than you might have
expected. Earnings do count, and when they are
interrupted by loss loan cycles, the stocks predictably
suffer.

Structural Challenges

'91

The banking industry is trying to solve some problems by cutting costs-alone and through consolida-

- - Prime Rate
- - - Three-Month CD Rate
- - - - - Money Market Rate
Bank Margins/Spreads
6,----------------------,

Figure 9. Spreads on True Costs


800,-------------------,
700
600
'" 500

.5

~ 400
.~

300

100
O'----...L-----'-------'-_ _L-_--'----_---L_----.l_----l

'84

'85

'86

'87

'88

'89

'90

'91

- - - Regional Bank Margin


Prime--Money Market Spread
- -Money Center Bank Margin
Prime--Three-Month CD Spread

Source: Goldman, Sachs & Company.

O'------'----"'-------'-_.L......---'--_-'-----'-_-'-----'-_--'------'---.J
'80 '81

'82 '83 '84 '85 '86 '87 '88 '89 '90 '91

- - Prime--Discount Rate
- - - Prime--Cost-of-Funds Proxy
- - - - - Prime--Federal Funds

Source: Goldman, Sachs & Company.

13

tions and mergers. The capacity issue in banking is


schizophrenic. Is the problem over- or undercapacity? If you look functionally at the industry, capital
is still short; it is certainly not in excess. So functionally, lending capacity is a problem because the system lacks capital. That may not be as apparent at the
low point in the credit demand cycle, but it is there.
Even if all the banks were merged into one, we would
still have that problem.
Structurally, that is a different matter. Because
of its history, the US. banking system is the most
fractionated industry in the world. There are too
many banks and too many branches. That is a different kind of capacity-delivery capacity. This is a
natural offshoot of all of the restrictions the industry
has lived under. As a result, the game is going to be
delivery inefficiencies. Branch reduction is important, but the back office is the true key.
Table 2 lists five recently announced mergers in
order of branch overlap-Society/ Ameritrust (high
overlap) through Fleet Norstar /Bank of New England (limited overlap). If you look at the savings in
expenses as a percent of the target bank in all of these
deals, the opportunity for savings is curiously a consistent number whether it is an in-market or an outof-market merger. In showing the sources of savings, the table lists local items, such as retail branches,
on the left and fixed-cost items, such as overhead,
toward the right. At least half of the expense savings
are available regardless of market. I do not think
geography is going to matter as much as people
think. Cost savings will be the most important thing
banks can achieve over the next five years, and that
is how we are focusing our bank stock investments.

Figure 10. Household International Consumer Net


Charge-Offs to Average Receivables
6,-----------------------,

5
4

3
2

o'--_---'---_----'-'"'--_--'-_-----.J'--_--'-_-----.J_ _--'-----'
'29

Source: Federal Deposit Insurance Corporation.

14

'61

'69

'77

-----,

Figure 12. Price Change Differential versus Core


Earnings Growth Differential--Money
center Banks versus S&P 500
60 , - - - - - - - - - - - - - - - - - - - - - - - ,

50 \

:::ro~

20

is

..<:;

U
<Ii

J:

ca
2
:::

40:\
30 I \
I

10

\
f-+Ir--+-,.----I\------trt---jJ'--------t-J..il,t~-__+_i

-10
-20
-30
-40 '-----'-_'-----'-_'-----'-_'-----'-_L-----'---_L-----'--------'
'80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91
- - Price Differential

'80

'84

'85 '89

Try to understand banks, and then select among


them. This is a people business, and the key is to
meet the managements and get comfortable with
them. If you cannot, or if they cannot meet you, look
somewhere else. After the fundamental analysis is
done, there are two questions an analyst should ask
bank managements about their banks. First, ask the
CEO, "Do you know what a TIline is?" A TI communication line is a digital line that allows the bank
to deliver a back office systems capability from Denver to Dusseldorf. Digital communication was invented decades ago and became commonly available
by 1980. A few banks figured it out in 1985. It
removes one of the shackles of geography from consolidation and delivering back office support. With

ca
:0

1.3
1.2
1.1
1.0
0.9
~ 0.8
~ 0.7
P-. 0.6
0.5
0.4
0.3
0.2
0.1
0'48

'53

Conclusion

Figure 11. Net Charge-Off Ratio FDIC Insured


Commercial Banks
1.4,----

'45

Source: Household International.

'88'90

- - - Earning per Share


Growth Differential

Sources: Goldman, Sachs & Company; company reports.

Table 2. Out-ofMarket Merger Potential Expense Reduction Mix Spectrum


In-Market (Branch Overlay)/Out-Of-Market (Systems and Operations)
Society/Ameritrusta

$millions mix
Percent mix

Retail
Branches

Commercial
Banking

47.5
37

10.1
8

Trust
8.6
7

Corporate
Overhead

EDP&
Operations

37.2
29

25.3
20

Systems

Operations

BankAmerica/Security Pacificb
Consumer
Delivery
$millions mix
Percent mix

350
35

Wholesale
Delivery

Other

150
15

100
10

200
20

200
20

Chemical/Manufacturers Hanover c
Branches &
Real Estate
$millions mix
Percent mix

100
15

Staff

Technology &
Operations

350

200
31

54

NCNB/C&S Sovran d
In-Market
Branches
$millions mix
Percent mix

Marketing

Business
Lines

25
7

47
13

Branch
Banking

Other
Line

Staff!
Support

20
8

55
21

108
31

Corporate
Overhead
44
13

Support Services
& Operations
126
36

Fleet Norstar/Bank of New Englande

$millions mix
Percent mix

100
38

Systems &
Operations
90
34

Sources: Goldman, Sachs & Company; company reports.


Note: Mergers listed in order of high-branch overlay.
a30 percent of target: $129 million run-rate save.
percent of target: $1,000 million run-rate save.
c33 percent of target: $650 million run-rate save.
d 21 percent of target: $350 million run-rate save.
e41 percent of target: $350 million run-rate save. Ex-Special asset pool cost save 34 percent of target: $265
million run-rate save. Close 50 of 323 BNE branches.
b 32

one simple exception-that you must have checks


delivered locally to clear the Fed-everything else
can be done remote. Other than that, geography is
not a limit.

The next question is, "00 you have common


products and systems across your existing geography?" These two questions will tell you whether the
bank is really "cooking" in the consolidation phase.

15

Question and Answer Session


Robert B. Albertson
Question: If capital requirements as a percentage of total assets are expanded to 5 or 6 percent, and a bank can get a 0.8 percent return on assets, its return on
equity is 16 percent at 5, but at 6,
it is only about 13.6. That starts
to go from okay to pedestrian.
Can we be overreacting on the
capital side?
Albertson: No. When a bank increases its capital and reduces its
return on equity, investors pay
more for the stock. Bank stock
prices do not go down one-forone when they do common offerings because of dilution. There is
something special about capital
in banks. I think the real question
is this: Should a bank be able to
earn 80 or 100 basis points return
on assets, or are we just kidding
ourselves? We applaud all of
these banks that finally get there,
and we forget that they have been
living in an industry in which efficiency has never really been a
focus. I think we will see decent
return on equity numbers for
banks when the return on assets
rises well over 100 basis points.
Question: Will banks tough it
out on the efficiency side to close
the gap?
Albertson: All banks are focusing on efficiency. Even those that
are not merging can somehow
eliminate up to 10 percent of
costs in a year.
Question: The credit card
challenge is in the public domain.
Somebody asked how much subsidization of bad credit debt are
consumers paying for at 18.9 percent. Obviously, a good bit if the
losses range around 5 percent.

16

On the other hand, all the major


issuers have had better rates for
better creditors. How do you see
the credit card business evolving?
Albertson: Maybe the only time
to invest in bank stocks is the two
months in which Congress is out
of session. This issue is very visible, and everyone seems eager to
hop on a populist bandwagon. A
little global perspective would
help. Even if you are the best customer at Harrod's, the rate on its
card is 32 percent; a Barclay's
card is also 32 percent.
The problem is that the credit
card's functional purpose has
been misperceived. It is not intended as a primary financing vehicle. If a consumer is using it accordingly, they are misusing it.
The average consumer borrows
$800 on the card. The card is really two products, and maybe
they should unbundle it and
price it as such to get away from
this risk. If I borrow $800 at 19 or
20 percent, I am spending close to
$150 a year on interest, which is
foolish. On the other hand, I receive with the card a free checking account that works everywhere I go. That is worth something each month. If you ask for
a simple checking account, it
would cost you more than $4 a
month if you do not keep minimum balances. So after deducting a fee for checking, the average
bank card user is really paying
$90 a year in interest, or 10 to 12
percent. The card is subsidizing
between functions, and banks
have to learn how to reprice that,
unbundle it, and delineate the
transaction device from the rate
paid on the borrowings.
Currently, people who use
the card purely as a transaction

device are being subsidized by


the higher rate paid on outstanding balances. I mentioned that
the industry earns 300 basis
points pretax. If they all went
down to 14 percent, half of that
could be completely recaptured
by charging interest the day of
purchase instead of after a 30-day
grace period. Banks have a lot
left that they can work with to
keep this business profitable.
Question: Banks have seemingly had an infinite capacity to
dig their own holes. It was obvious with the lesser developed
country debt, when Wriston said,
"No country shall go broke." We
have seen the carnage in real estate loans. Then there were the
highly leveraged transactions.
What new holes are they going to
dig, or are they going to learn
their lesson somewhere along the
way?
Albertson: Banking is a cyclical
business. Part of the cycle is that
a recession should produce losses
and make bank earnings go
down. Where we messed up is
not in the actual business banks
get into but in their tendency to
forget that the government can
make them a lot worse in times of
distress. The lesser developed
country exposure and losses
would have been far less had the
government not encouraged such
lending in the first place, then
pushed so hard for debt forgiveness. If the government had not
interfered, we would not have
had this problem. We would
have had a cycle, banks would
have lost some money, but it
would have become better.
Commercial real estate is
very much the same thing. We

had overbuilding in 1975, but we


came out of it. The difference is
partly that we had inflation to
help then and different demographics. What we have now is
the Financial Institutions Reform,
Recovery and Enforcement Act,
which has basically made it a felony to misappraise property.
Now, if you are an appraiser, you
would be trying, with fear as
your motivator, to lowball your
appraisal. That results in making
the downside on these properties
unrealistically low. Now, the regulators are asking banks to mark
real estate to market, even when
loans are performing.
Banks are supposed to lend
to borrowers who need the
money and cannot directly tap
public markets at favorable rates.
By definition, this is an "illiquid"
instrument in most cases. This is
their real function. They are not
supposed to be securities firms.
When regulatory distortions add
to the effects of the cycle, they are
in trouble.
I do not see any new problem
credit areas at this juncture,
partly because banks do not want
to lend. They have pulled back.
In 1975, there was the same question. When are the banks going
to dig the next hole, and what is it
going to be? We had an oil industry problem then. The answer
was proposed to be tankers and
nuclear utility loans, and neither
hit. So I think it is a cycle. We
are almost through this one. We
will have another period like this
again-probably in the late 1990s.
Question: If regulation gets
more severe and limiting, do you
think we will see any denouncement of bank charters?
Albertson: Yes. If you are a
banker, and you have been watching all of this happen, you know
what you do not like. The reason

you accept regulation now is simple-you are insured. If you can


find a way to stop using consumer deposits, you do not need
that bank charter. If you can find
a way to fund yourself otherwise,
you are going to get out of this
business. Several banks, such as
Morgan, have looked at this possibility in the past. If one or two of
them actually try it, I think that
will reverse the regulatory process. The reason the government
has its hooks in banks is because
it is insuring them. That is only
fair. The regulators want to
know where the money goes,
they want control over it, and
they want banks to pay when it
goes bad. But it has gotten to an
extreme.
Question: Some banks, Morgan
for example, can do underwritings. Obviously, a bank must
qualify for this on some kind of
prudent basis. Will we see more
of that, and will that rattle the traditional underwriters?
Albertson: I think investment
bankers have a big problem here.
For underwriting to help banks, it
will have to be a pretty big business. If you add up all of the profits made on Wall Street and divide it among 10 large banks and
20 smaller banks, it is a "good living" for very few. If all of the big
banks and some medium-sized regional banks went into that business, there will probably be serious price competition.
Question: One of the things you
do is try to get some perspective
on future corporate lending. That
Goldman, Sachs & Company survey of chief financial officers
looked positive recently, which is
unusual in this environment.
Please comment on this.
Albertson:

In April, our survey

of corporate borrowers said we


were going to have a borrowing
boom because cash flow in the
corporate sector was tight. In the
latest survey, cash flow for the
1992 period according to corporate treasurers looks much better.
This means they are not going to
need banks as much, so the credit
demand in commercial lending is
now coming back down to a low
single-digit level. I am happy to
see the cash flow of the corporate
sector firming up because that
will help the economy. I do not
care about having loan growth
right now, and loan growth will
be very sluggish until later in
1992. The banks that will make
the money are the service providers that do more than just lending
anyway. In this same survey, we
asked the CFOs of Fortune 500
companies how much they pay
their bankers for things other
than lending, and the answer was
an astonishingly high 40 percent.
Cash management, trust, and derivative products are where the
growth will be in the next few
years.
Question: What predictions do
you have for Southeast bank
mergers?
Albertson: I think the big local
mergers are over. North Carolina
National Bank is doing something that others do not have the
heart to do, which is to take over
a big company and say that what
they are really acquiring are 500
more branches. I think what you
will see in the Southeast are small
and medium-sized fill-in deals.
That is all you will probably see
in the rest of the country, too,
with the exception of the Midwest, where a couple of megamergers are due.

17

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