The New Industry Realities

Major challenges and opportunities will dominate the world of banking over the next three years. The winners will be some of the prominent financial institutions now emerging, along with those community banks that seize the moment and capitalize on their opportunities.

While the focus of this article is the major challenges ahead, the news is not all bleak for banking. In fact, the next article in this “New Industry Realities” series will discuss the many opportunities that lie ahead for banks.

Earnings and the prices being paid for financial institutions are at record highs. This is “the best of times” to date. And yet, many of the most astute bankers I know are starting to ask fundamental questions about how long it can continue and, most important, what they should be doing now.

First, let me say, I personally hope it continues on to ever-greater heights, but I doubt that it will for one simple reason: All the erudite explanations as to why we are in a new era are too pat, too easy, too universally held to last forever. Speculative excesses always end.

The underlying challenge for bank management is to start preparing for a more competitive environment. The decision for owners is whether to seriously consider selling at high multiples or, alternatively, to aggressively capitalize on the significant growth opportunities created by mergers that are dislocating literally thousands of profitable bank customers.

The banking industry today reflects a composite of three very powerful forces. First, the industry has recently been exceptionally profitable, whether viewed historically or relative to other industries. Second, consolidation is rapidly reshaping the entire competitive structure of the financial services industry. Third, virtually all financial services lend themselves to being low cost, smoothly delivered commodity services, and with substantially narrower profit margins than today.


Earnings have grown dramatically over the past six years for all financial institutions including banks, thrifts, and savings banks. Their combined pre-tax operating income increased 333%, rising from $24 billion to an estimated $103 billion. During the same period, total assets in financial institutions grew 33%, rising from from $4.6 trillion to an estimated $6.1 trillion. The bottom line on earnings: Financial institutions in the last six years from 1992-1997 made $473 billion pre-tax operating income. In the preceding six years years from 1986-1991, financial institutions made $110 billion in pre-tax operating income. Financial institutions thus made $363 billion or 332% more pre-tax operating income in the most recent six-year period, than in the preceding six years.

“A picture is worth a thousand words.” Just the same, I would like to add a few words to the Financial Institutions Earnings Growth graph (see figure). An interesting way to look at the graph is in terms of where the $79 billion increase in pre-tax operating income came from for the period 1991 through estimated 1997. Net interest income increased by $52 billion, the provision for loan losses decreased by $20 billion, and net overhead expense decreased by $7 billion. Many bankers believe that interest rate spreads will be narrowing, the provision will be increasing, and net overhead will be going up over the next three years.

The two important questions facing senior management, boards of directors, and major shareholders are:

  • How sustainable is the current level of earnings for all financial institutions as a group? And more specifically, what is the outlook for their individual institution? The rising earnings tide over the last six years lifted virtually all the boats in the harbor. What will a falling tide do? Or maybe we are in a New Era where economic tides and cycles no longer exist and speculative excesses never happen oru00e2u20ac”maybe we aren’t.
  • How fast can earnings grow in an increasingly price competitive environment? The major product lines of deposits and loans are becoming highly commoditized in the customer’s mind. Many competitors are trying to buy market share quickly through aggressive pricing rather than growing market share more slowly through product differentiation and branding. Some major financial institutions are simultaneously doing bothu00e2u20ac”albeit in different markets.

The bottom line on earnings is that everything is working incredibly wellu00e2u20ac”yet bankers all around the country are privately expressing concern to me about the sustainability of the current level of earnings. As I visit with bankers and talk with our consulting staff, a number of concerns keep coming up. Here are five of the most frequently mentioned.

Five major concerns

Asset Quality: Too Good To Be True

Asset quality, after improving dramatically over the past six years, is now starting to be an area of potential concern, especially among high performance banks. Their focus is on the following list of suspects: consumer loans, rising personal bankruptcies, increased real estate values driven in part by low interest rates, and the easy availability of commercial loans, often thinly priced and sometimes with no personal guarantees required. The great unknown is what impact the year 2000 problem will have on the economy, individual borrowers, and loan quality.

The possibility of deflationu00e2u20ac”Inflation is almost always the banker’s friend, especially regarding the loan portfolio. Collateral values increase and economic activity increases with the resulting positive impact on customer cash flows. Deflation presents the opposite challengeu00e2u20ac”sinking asset values and slowing economic activity.

The specter of deflation from whatever source, whether it’s the domino effect of the bursting of various Asian economic bubbles or excess production capacity, or whatever, can easily create a perception of economic problems ahead that will slow activity, cause stock markets to fall, etc. All bankers can vividly remember their last experiences with deflation, and the memories are not happy ones.

The conclusion is simply this: The risks of being a very aggressive lender in this environment far outweigh the potential rewards, especially if risk means chasing potentially problem credits that are priced with very thin margins. As one banker told me, “Been there, done that.”

The case for stepping backu00e2u20ac”Banking is fundamentally a highly leveraged business. Today, the potential rewards appear inadequate for aggressively taking on credit risk, particularly during what could be a turbulent part of the cycle. For some selected banks, this environment may represent a tremendous opportunity for growth. However, many bankers, as they try to surpass their record earnings of the past year, might want to refer back, way back, to something Adam Smith said in The Theory of Moral Sentiments:

“Examine the record of history, recollect what has happened within the circle of your own experience, consider with attention what has been the conduct of almost all the great unfortunate, either in private or public life, whom you may have either read of, or heard of, or remember; and you will find that the misfortunes of by far the greater part of them have arisen from their not knowing when they were well, when it was proper for them to sit still and be contented.”

Many bankers I know are focusing exclusively on quality loan growth and, most important, are starting to clean up their existing portfolios. The reasoning is simply this: It’s much easier to move a potential problem credit out of the bank in good times than in bad. Not exactly rocket science, but it takes a lot of discipline and foresight to actually move a currently profitable loan out of the bank, knowing full well it will negatively impact earnings short term.

Interest Spreads Narrowing

Interest spreads are narrowing due to both Federal Reserve policies designed to achieve price stability and, even more important, the increased price competition for deposits and loans in virtually all markets.

Loan pricing is a clear example of this dramatically increasing price competition. For example, LIBOR-based commercial loan pricing is even coming into some rural markets. When bankers in small Alabama towns start having to compete with LIBOR-priced, long-term, fixed-rate commercial loans, you know that the product will be offered to small businesses across the country. Community banks will probably not lose their commercial loan business but will frequently have to give up some margin to keep it.

Traditional Noninterest Income Growth Slowing

Increasing noninterest income from traditional means such as service charges on deposit accounts is becoming much more difficult to achieve. Most banks have already increased fees and significantly reduced waived fees, in effect, picking the “low fruit.”

Noninterest income from nontraditional sources such as discount brokerage, investment banking, investment management, and annuity sales, while intriguing, is not yet producing meaningful recurring income for most banks.

Salary Requirements Escalating

The salaries required to attract, retain, and motivate good employees from entry level to senior management are increasing, often dramatically in some regionally tight labor markets. Some of these wage increases are being offset by significant gains in productivity. But there is an even bigger issue: I firmly believe that the major challenge will be to keep the really good people that are the key to remaining competitiveu00e2u20ac”especially when the bank’s greatest perceived strength is good quality, personalized service.

The identity of highly profitable customers is becoming common knowledge due to the effective use of marketing databasesu00e2u20ac”it’s become Sales and Marketing 101. Sharply focused competition for those customers is becoming a competitive reality. As a result, many of those highly profitable customers want personalized servicesu00e2u20ac”not directions to the nearest ATM. Competing for bank employees who genuinely care about customers in each market will become the next competitive battle field. This will be especially true for exceptionally good relationship management and customer service personnel.

The Cost Of Winning

Selecting the best-qualified, sales-oriented employees from existing staff, recruiting new sales-focused employees, and providing professional training is becoming the competitive imperative for all banks. Community banks face a special challenge because many of the larger institutions are already moving rapidly down the road toward significantly improving personalized services for their most profitable customers.

The labor cost implications of this increased competition are clear. First, highly effective existing staff will, in many instances, be receiving offers from competitors including higher base salaries plus performance-based incentives. The alternative, however, is pretty clear: Either build the sales effectiveness of the bank or risk losing the most profitable customersu00e2u20ac”obviously not all of them, but enough over time to negatively impact earnings and the value of the institution.

Second, attracting new, highly qualified staff will, in some instances, be expensive and raise internal expectations. The saving grace is that sales compensation is tied to measurable sales performance.

Third, significant investment in both professional training and customer information management will be required to be competitive. Winning will call for very focused management attention on customer retention.

Normal Technology Expenses Plus the Year 2000

Technology expenses are going to be increasing for many banks just to stay even from a competitive viewpoint. Most important for the short term will be the management focus required to adequately address the year 2000 problem. Five things are clear regarding the year 2000:

  • January 1, 2000 won’t go away.
  • A surprisingly small number of banks are taking the problem really seriously, although the number is increasing daily.
  • In 1998, the regulatory agencies will make the year 2000 seem like their whole reason for being.
  • Investors will sharply focus on who is ready and who isn’t. Watch for short-selling pressure on the unprepared larger institutions.
  • Many financial institutions will have a choice of either reducing other expenses such as investments in new technology or reducing earnings to pay for the year 2000 expenses. One can easily envision a new line on the income statements. “Nonrecurring expense associated with the year 2000.”

The bottom line: Focus immediate attention on fixing mission-critical core applications. (If the elevator doesn’t work on January 3, 2000, don’t worry, take the stairs.) And equally important, start focusing now on accurately understanding how well prepared your top-tier customers, both depositors and borrowers, will be to meet the year 2000 challenges to their businesses.


The consolidation of U.S. financial institutions is entering its final stages. The actual pace of consolidation will be driven by three overriding factors.

The prices being paidu00e2u20ac”If the stock market valuation being placed on the acquiring institution remains high, enabling stock-for-stock transactions in excess of 3X book, then many bank owners will say, “This is all too good to be true, so let’s try to get those prices while we still can.”

The earnings outlooku00e2u20ac”If earnings start to flatten or begin to actually decline for reasons that appear likely to continue for the long term, e.g., spreads narrowing due to price competition, then some bank owners will start to question the long-term wisdom of owning the bank versus other investment opportunities.

Competition for profitable customersu00e2u20ac”If larger financial institutions start demonstrating an ability to not only retain their most profitable customers but gain share of wallet of those customers, and in the process start attracting new profitable customers from other institutions, then some bank owners will determine that “it’s better to sell while we still have a strong, profitable customer base than wait until it’s being eroded away.”

To complete the picture, the ongoing necessity of making investments in new technology just to stay even, and in some cases the very real pressure for some institutions to sell based on year 2000, will drive consolidation.

Within this backdrop of massive consolidation, major new financial institutions are emerging. Relative size, in terms of market capitalization, earnings, capital, and assets, is determining who are the acquirors and who are the targets. Just looking at asset size, at a time when there exists institutions that are $300 billion or larger, $100 billion institutions are fast becoming “targets.” The challenge often is to make the deal work at senior management levels (read “Chairman and CEO”); the rest is downhill.

In a world of $100 billion targets and strong personalities driving the acquirors, the numbers can almost always be made to “work” to justify the high premiums being paid. Where there’s a will, there often is a way, even if it means that the acquiror’s current stockholders are not short-term winners.

Commoditizationu00e2u20ac”and fighting back

Financial services lend themselves to being commoditized. A deposit is a deposit is a deposit. Likewise for loans and lots of other services. A major characteristic of commodities is that over the long term, they are bought and sold primarily based on priceu00e2u20ac”because, quite frankly, they are often the same in every other respect.

The challenge for financial institutions is how to differentiate, through the product itself and the accompanying service and branding, what is basically a commodity product and do it with good profit margins. Good profit margins are a reflection of pricing and delivery costs. Some banks will work to provide more personalized service and, hence, justify higher prices. Others will focus on low-cost delivery. Some will do both simultaneously, creating confusion in the mind of the customer. But in any event, the level and complexity of sales and marketing efforts are going to dramatically increase. Most important, the technology, and the knowledge to make it all work, are coming together for those who really want to effectively compete.

Can the banking industry fight commoditization? Definitely, yes. Witness the success of Starbuck’s coffee. They took a commodityu00e2u20ac”a cup of coffeeu00e2u20ac”that was so much a commodity that you often got the second one free! Starbuck’s added quality, freshness, and convenience plus a special ambiance around the product delivery, turning a commodity into a $3.00 a cup experience. Drinking one cup a day costs $1,095 per year, plus tax.

The only better commodity story I know of is taking colored water, adding sugar, and calling it Coca-Cola.

The power of personalization

At the end of the day, providing more personalized banking services is the community bank’s most powerful competitive weapon. Ironically, “providing more personalized banking services” is also proving to be the Achilles heel of some merging institutions.

The bottom line is that the future is very bright for those community banks that are truly committed to capitalizing on their opportunities. In our opinion, the success stories in the future will be about those banks that, early on, recognized this “wonderful window of opportunity” and, most important, invested in intelligently building highly profitable customer relationships. We’ll talk more about opportunities and the rewards of winning in the next installment of this series on the new industry realities.

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