A Fresh Perspective on Bank Stocks

Bankers who are puzzled by the lackluster performance of their stock despite the technology-driven bull market need to update their strategies now if they are to survive and thrive in the post-reform era.Bank stocks have lagged the phenomenal performance of the stock market as a whole, especially high-tech and Internet stocks. Many bankers and analysts alike seem to be perplexed as to why banks with strong earnings are being left behind. But Richard X. Bove, director of banking and financial services research, and senior vice president, Raymond James Financial, has studied the problem and says banks are working from the wrong model. They should adopt a model suited for today`s market by adapting their strategies to what investors now value in the market.Dick Bove has been an analyst for more than 30 years, during which time he was selected for the Institutional Investor All-American Team on nine occasions for his coverage of the banking and building industries.Bank Director: Let`s start by looking at the performance of bank stocks.Richard Bove: For the past 12, perhaps 18, months, we`ve watched the prices of bank stocks-for that matter all financial stocks-move consistently lower while the market is moving higher. So we forced ourselves to take a look at why that is happening and that caused us to go back in time to try and understand what the banks are doing that makes them so unattractive to this market. We didn`t think that the simplistic argument of interest rates are going up or there`s going to be higher levels of bad loans was adequate to explain the huge disparity in valuations that has developed between bank and Internet stocks. And while people may think it`s silly to compare a bank [stock] to an Internet stock, we think it`s valid, because what we are talking about is access to capital within a capitalist system. And if banks become the high-cost buyers of money vis-u00c3 -vis Internet companies, then, ultimately, an Internet company can take away a bank`s business. This study began back in 1970 when the banking industry was impressed by Walter Wriston`s call that banking companies could grow at 15% forever, if they simply made a couple of adjustments. The first was to create a bank holding company instead of a bank. The second was to broaden the reach of the company, both in terms of the products being offered and the markets being served. In 1972-1973, when the first oil shock hit, banks were given money by Arab countries to invest in Wriston`s goal. The net result is that every bank in the 1970s was run for maximum growth. And in that period, banks invested or loaned money to the oil industry, the real estate industry, emerging nations, the leveraged buyout industry-and bank earnings skyrocketed. It was a period of great prosperity until 1980 came along and Paul Volcker was made head of the Federal Reserve Board. Basically, he caused a large portion of the American economy to be hit with deflation. The price of oil dropped from the $40s to the low teens; in fact, it actually broke $10. The price of a square foot of real estate dropped from the high $20s to the low teens, in some cases falling almost to zero. The price of virtually every basic commodity fell. And all the companies that banks had loaned money to-because banks are basically asset lenders-were going bankrupt. Now it wasn`t that the banks had made bad loans, it was that nobody calculated for deflation. But deflation happened, and the model that Walter Wriston developed for running banks became obsolete-and not only obsolete, it became synonymous with bad banking.In other words, it was a good model, but because of deflation, the basis moved? Exactly. In an inflating economy, which is what 1970 was all about-with the highest rate of inflation since the Civil War-lending against assets made a great deal of sense, because the assets kept going up in value. If, all of a sudden, you move the basis, and you`re not in an inflating economy, you`re in a deflating economy, then everything you were loaning money against is now losing value, and your loans are going bad at an incredible rate.So in the mid-1980s, Carl Reichardt, who was CEO of Wells Fargo, decided that a new banking model was needed. He developed a model that just about every major bank in the United States has followed throughout the 1990s. That model was based on a totally different approach to the industry. What Reichardt said was, I am not going to grow my balance sheet, but I am going to try to get the highest yield possible out of that balance sheet by shifting out low-return assets-mortgages, Treasuries-and putting in high-return assets-consumer loans, home equity loans. And on the liability side, I am going to get rid of high-cost funds and big-ticket CDs, and I am going to replace them with core deposits. But I am not going to grow the balance sheet. What I am going to do is increase the yield on the existing balance sheet through better asset liability management. The second portion of his program-because you did have to get growth-was to grow noninterest income. The primary technique used to grow noninterest income was to take assets that would normally be put on a balance sheet, securitize them or syndicate them, then sell them, generating high levels of noninterest income growth. In addition, you would reprice or unbundle most of the services offered by the bank. Noninterest income also was driven by specific businesses selling data-processing products, etc. The third element of Reichardt`s program was to reduce the cost of running the business. If you go back to the theory that if you`re not increasing deposits, you`re not increasing the size of the balance sheet, then you don`t need lots of branches. And if you automate heavily, you can change systems and reduce the labor intensity of the business, thus substantially reducing the cost of running the business. In addition, if you took a very hard-nosed look at the businesses you were running, you would eliminate all those businesses that you didn`t think would meet certain hurdle rates of return and you would sell them. And that led to the fourth part of Reichardt`s program. You are now generating this tremendous amount of net income because you are getting a higher yielding balance sheet. You`re increasing your noninterest income, and you`re lowering your cost of operation. So you take that net income and you buy back stock.