Welcome to the new new economy. With the official turn of the millennium, we are witnessing the convergence of what could become a broad-based economic slowdown and intense competition for profitable businessu00e2u20ac”a climate that is driving a new set of priorities for financial institutions. The winners will have sound loan portfolios, strong financial performances, and clearly defined strategies to keep their best customers. As a result, two tiers of financial rewards affecting shareholders and employees will emergeCompared to those of weaker-performing institutions, stockholders of strong institutions will be rewarded with higher price earnings ratios and more attractive opportunities to either grow independently by acquisition or be acquired at substantial premiums. Employees of strong institutions also will be better compensated and have more career opportunities.
The credit quality challenge
Many bankers have consistently predicted significant credit problems, ranging from loans to lesser-developed countries to commercial real estate lending. The basis for their predictions was a combination of sound banking judgment coupled with something I like to call “common sense economics.”The impact and ripple effects of these credit problems often were confined to a geographic area or to specific loan categories. In some instances, a relatively small group of banks were affected, as in the case of loans to lesser-developed countries. In other instances, such as commercial real estate, a large number of institutions felt the blow in certain regions.Today, we are once again on the verge of major credit problems. The difference, however, is that the impact could be much broader. The potential for a broad-based economic slowdown clearly exists. The speculative stock market excesses, which drove not only valuations but also consumer and corporate spending, are now disappearing. Many businesses are reevaluating or cutting back on capital spending and expansion plans. Moreover, we are beginning to see a major focus on expense control to improve corporate profits as revenue growth slows.
The core problem
We anticipate a slowdown in the demand for commercial real estate, corporate borrowing, and corporate equities, especially as they relate to technology. Associated suppliers and service organizations will all be hit. Keep in mind, it`s not only the Ferrari dealer that will suffer but also restaurants, retailers, residential real estate values, etc. And in many markets, the demand for commercial space is tied directly to the ability of businesses to raise investment capital.As long as the financial carnival goes on and the music doesn`t stop, everything is fine. Unfortunately, volatile financial markets affect the ability of investment bankers to raise funds for their clients, especially new ventures. The effect is like going over a cliff, i.e., their ability to sell securities virtually stalls, often abruptly. Sometimes the enterprise and its investment bankers are moving so fast that they go over the proverbial cliff without leaving any skid marks. The landing is hard and fast for enterprises in need of financing.To a great extent, the principal sources of funds for many investment bankers are their Rolodexes. Commercial bankers will become much more popular simply because they have deposits to lend to qualified borrowers … not phone numbers to call to sell securities.
The negative wealth effect
The concept of “the negative wealth effect” has received some attention over the past few years. Now we are entering a real-time experiment wherein a lot of individuals and businesses are watching their income statements, balance sheets, and, most important, cash flows shrinking rapidly without the realistic prospect of a quick rebound. In short, we are entering a period when commercial bankers will be called on to fill the gap left by other financing sources. Here are a few thoughts:
- Look hard at individuals and businesses whose cash flows are closely tied to the stock market and to continued access of capital markets.
- Recognize that a general economic slowdown could easily spiral, especially if public perception starts to become increasingly negative or apprehensive about the near term. Don`t place great reliance for making credit decisions on current economic statisticsu00e2u20ac”they will likely reinforce the perception that things are only slowing down slightly. Try instead to focus on what you think conditions will be when the loan needs to be repaid.
- Realize that the impact could be felt nationwide. The especially vulnerable geographic areas are those that have experienced extremely high growth in economic activity and where real estate prices have skyrocketed. Silicon Valley wanna-bes may be among the most vulnerable.
- Question your basic assumptions regarding all major areas of credit exposure … except, perhaps, loans made to the U.S. government. A fundamental question has to be, “In making this credit decision, what am I missing regarding the borrower`s future cash flow?” It`s likely common sense will provide you the answer.
- Understand that credit-driven or-dependent business could easily experience fundamental pressure. Despite the collateral values or the apparent strength of the cash flowsu00e2u20ac”if no one will lend a business money, things can get very difficult, very fast.
Responsible expense management
High-performance management will always be looking for ways to increase revenues and reduce expenses while improving customer service. As a result, solid growth and strong profitability often go hand in hand.The powerful combination of efficiency, excellent customer service, and profitable growth can be seen in leading banks throughout the country. In addition, we see many CEOs executing a carefully planned strategy to change their cost structures for the ultimate long-term benefit of their shareholders, employees, and customers. The efficient organization has the financial flexibility to invest is its future, whether it be in people, marketing, or technology.As you might expect, a handful of banks are in denial regarding opportunities to increase current earnings. They point to overly zealous or clumsy attempts to reduce expenses, which has impaired customer service at some banks. Our consulting experience has found that customer service actually improves as processes are reengineered and new technology is adopted.Likewise, we have always strongly recommended performance-based compensation for senior management. Quite frankly, superior compensation for superior management, as measured by current operating results or significant improvements in performance, is one of the best investments a board of directors can make.
The new face of corporate lending
The lack of availability of the junk bond and public market financing for many companies is going to diminish the quality of commercial loan portfolios, especially in some of the major banks. That`s the bad news.The good news is that the ongoing ability to provide financing is going to become even more valuable and profitable than in the past. Many corporations are now deciding that their commercial banker is their new best friend.Financing sources with deep pockets are going to enjoy a burst of popularity, whether they are banks, corporations, individuals, pension funds, or venture capital funds. The key is having the funds available. Banks will be presented with an array of opportunities for profit beyond return of principal plus interest. But selectivity is going to take on new meaning.The bottom line is that we are entering a period when having cash is going to draw opportunities. The balance of power is clearly shifting to the lender. Price competition will lessen. Most important, competition in terms of who can provide the weakest loan covenants will finally decrease.
Profitable customer retention
The knowledge of what it takes to hold onto your best customers in the new economy is becoming much clearer. The new economy is not dead, only some Internet stocks are. The delivery of a broad spectrum of services over the Internet will revolutionize the way banking business is done. Of importance for many banks will be the application of new Web-based information technology to lock in the bank`s best business customers and, over time, lock out the competition. The key is understanding the fundamental nature of the relationship between the bank and its business customer, coupled with an in-depth knowledge of where technology is going and how best to use it. The problem is not simple. The winning solutions will successfully integrate a wide range of technology partnerships with banking experience and front-line implementation know-how. The results of this approach, in terms of immediate payback as well as potential long-term benefit, are significant, but ultimately require total organizational commitment. I would strongly recommend that senior bank management establish a special group or team to address Internet-based opportunities. During 2001, virtually every major banking organization will be launching a new suite of services aimed at retaining business customers. There will be clear winners and losers based on technology selection, strategic partnerships, and execution. At each step the potential exists to make a fatal error. For example, choosing the wrong technology, having a poor product selection, or a lack of staff training may forever hamper the organization in its efforts to surpass the competition. The net result is rethinking, regrouping, and reinvesting. The major losses are time and money…and often lots of both. During 2002, committed financial institutions will experience significant and measurable results, both in terms of customer retention and increased fee income. By 2003, less than 24 months away, the landscape of services provided by financial institutions to their commercial customers will be rapidly changing forever. Most important, the winning banks will have locked in their most profitable customers while adding new and renewable sources of revenue. The opportunity to make the right decisions is clearly at hand. The rewards will be substantial in terms of customer retention, increased fee income, and gaining market momentum. At the end of the day, what really matters is not so much having the opportunity, but capitalizing on it.
The bottom line
The next 24 months are going to be most challenging from an economic viewpoint.Maneuverability in the loan portfolio may decrease dramatically if there`s a recession. The opportunity to improve efficiency and thus increase profits, however, will remain for many banks. And most promising for the longer term will be the chance to utilize new Internet-based technology to win the competitive battles ahead.The changing economic, technological, and competitive environment is going to place a high priority on strong bank management. Winning the talent wars will be critical for success. The bank`s basic challenge is that the rising economic tide that lifted all boats is going out. Now it`s up to management to make the difference.The bottom line is that the business of banking is going to get tougher, but the long-term rewards to the best banks will be considerable. This is just a hunch, but I believe we will see a two-tier bank stock market, wherein the market valuations of the banks with the strongest earnings will be substantially higher than those of the mediocre performers. The good news is that virtually every bank can either significantly increase or maintain a high level of earnings through sound management coupled with some good luck.