Watching the Economy

The rolling corrections of the stock market over the last year have revived concerns among bank stock watchers about credit quality. At the same time, there has been a host of new entrants in the banking market, vastly expanded interest in e-banking, and an uptick in bank merger activity. Put together, these indicators create more questions than answers for directors who need to make long-term strategic decisions for their institutions. In this environment, Bank Director asked Sean Ryan, principal, Banc of America Securities, to help make sense of the prospects for the industry.Bank Director: Let`s discuss the competitive landscape for banks today. A lot of companies, like Target and UPS, are starting deposit-banking businesses. Will that have a big impact on traditional banks? Sean Ryan: Not dramatically. There are over 8,000 independent banking companies, so it`s already a pretty granular landscape. A few incremental competitors shouldn`t have too much of an impact. The other thing is that it is not enough to just enter a business like banking, you have to actually be good at it. Banks that have been doing it for quite a long time have some edge. Certainly consolidation has left quite a bit of talent available for hire, but even so, I am very skeptical that it will become a meaningful competitive force any time soon. You say that banking is already granular, but those players are all banks. Do these new entrants present another model? Some of these entrants may have a fair amount of success, a Nordstrom getting a thrift charter, for example. If you believe as I do that the single biggest key to success on the retail side is consistently delivering superior service to your customers, then Nordstromu00e2u20ac”to the extent that it is able to translate its traditional strength in service to the banking marketu00e2u20ac”could become a meaningful player. But I think it is a breed apart and doesn`t represent the broad majority of entrants. That brings up another question related to technology. Are you bullish on e-banking? Bullish in what sense? Certainly I think the rate of penetration of non-online households will continue to increase. More and more people will bank online and pay bills online. I am fairly confident that that will not happen at the expense of banks that have large brick-and-mortar infrastructures, because relatively few customers are online exclusively. Most tend to be multichannel users, the PC simply being one of those channels. But if you look at some of Wells Fargo`s numbers, customers who use the online servicesu00e2u20ac”not necessarily exclusivelyu00e2u20ac”tend to have 50% higher revenue generation, 50% greater profit usage, and 50% lower attrition rates. So I think it is clearly something that banks of all shapes and sizes will be able to use to wrap their arms ever more tightly around their most profitable customers.Would you say that banks of almost any size should or will offer e-banking? I think so, yes. Even for small community banks, the benefits of scale are available at an affordable price through third-party vendors. It`s one more arrow in the quiver, but it`s not a silver bullet. Let`s turn to portfolio risk. There`s been some talk that the next downturn might be at hand. What is your take on credit quality? I think to some degree, the concerns are a bit overwrought, because we all know that with each year of this expansion, the market has tended to get a bit more frothy. Banks have given away, incrementally, more and more each year in terms of pricing and structure. There have been corrections, of course. In `95 and `96 when bankruptcies spiked up, banks were suddenly scared straight on the credit card front. In 1998, they were scared straight on the corporate front. That is beneficial, but it only lasts for a little while. That said, the outlook for the economy is such that we are likely to see more of the same. Some banks are doing foolish things but are getting bailed out by a strong economy. There will be exceptions. We`ve seen a couple blow-ups every quarter for the last several. I think that will continue. You will have individual banks getting caught. But we are unlikely to experience anything approximating the kind of broad-based carnage we saw in 1990 for example. Is this partially dependent on a strong economy? Right. It depends on both a strong economy and a more rational, or at least less irrational, competitive environment. Recall that during the last cycle, not only did you have the typical cyclical problems that emerge in mid-bank lending, you also had a competitive landscape that included Japanese banks that were flush with capital and buying up market share and that were indifferent to return. And you had zombie thrifts trying to bet their way out of the hole before regulators shut them down; they were making loans indifferent to risk and poisoning the pricing environment. Neither of those is the case today, and you also have consolidation that`s culled another few thousand banks from the market in the intervening 10 years. What effect do you think consolidation will have on credit quality? I think it is beneficial for two reasons. One is just culling out the weakest managements. Second, it creates larger, more diversified loan portfolios, reducing the risk of another Bank of New England or Continental. And it reduces competition, which is one of the factors that drives banks to do foolish or irrational things. Right. Over the past decade, we`ve seen the emergence of what you might call regional oligopolies. Individual markets have become less atomized to varying degrees. Some have become far more oligopolistic, others have consolidated somewhat but remain pretty atomized. But there are fewer competitors. Those who are no longer around tend to have been the most aggressive, least rational players. Not in all cases, certainly, but as a general trend, that has decreased the pressure to do irrational things on both pricing and structure. Is there any particular sector that you are concerned about? We are seeing a lot of individual problems with syndicated credits. That trend will probably continue. And while consumer credit problems have been in abeyance of late, if we get some unforeseen economic shock or sharper downturn than anticipated, the consumeru00e2u20ac”or at least a sector of the consumer market that is quite precariously perchedu00e2u20ac”could get shaken pretty quickly. Do you mean the credit card sector? Not credit cards specifically as much as consumer debt, where we have had dramatic growth. It`s interesting, because you have this sort of bifurcated market where you have some people who are living the good life by virtue of being in the Internet sector or somewhere else, who are buying their vacation homes for cash on the barrel head. Others are doing it by leveraging to the hilt. In a given market, you`ll have two tiers. One tier of customers is probably safe and sound; the other is very precarious. I really think that in this credit cycle we are likely to see much less uniformity in terms of where problems occur, both geographically and by business line and asset class. In 1989, if you just ranked banks by real estate exposure, that would have been a pretty good guide to how they would ultimately fare over the next couple of years. I think that`s less so now. What happened to credit cards in the `90s is playing out on a broader scale. There you had lots of regional banks that had lots of tidy little credit card portfolios. Then the monolines come along; they figured out how to measure and price risk much more effectively than anyone had done before. As a consequence, they grew rapidly through the `90s. The entrenched players thought they were doing perfectly well because they were doing what they had always done. It turns out they were being adversely selected without knowing it. Their competitors had much more finely honed measurement tools. So, you didn`t need a recession; all it took was a spike in bankruptcies amid rapid growth in 1995 and 1996 for that to really get shaken loose. For the monolines, chargeoffs rose, then leveled off and came down, and earnings kept growing at a 20% to 30% clip. But you had regional banks like Creststar or Mellon that were driven out of the business altogether. I think that kind of disparity is playing out on a larger scale. Almost irrespective of the environment, we`ll see an interesting disparity between some banks that continue to put up really outstanding, clean numbers and some that, even in a pretty robust economy, may suffer unduly. Any predictions? Well, that`s the tough thing. I cover a lot of banks in the Southeast. One of the CEOs has a great, colorful saying: “You never know who`s swimming naked till the tide rolls out.”What about the industry itself? How well could it withstand a downturn? Pretty well, I think. Not only is competition less irrational, but capital levels are far higher than they were in 1989 and 1990. That was the double whammy. Banks were overextended and then we had the recession and the real estate overhang on top of that. Now banks are very well capitalized and many are overcapitalized and buying back their shares pretty aggressively. And many of those continue every quarter to throw off substantial amounts of excess capital. Obviously you don`t want to take a loss regardless of how much capital you have, but at least we are at a point where banks will not necessarily be pushed to the brink of insolvency or forced into the capital markets at the worst possible moment, as happened 10 years ago. So, based on recent history, banks are very well situated to weather unforeseen problems. Consolidation slowed earlier this year, but now it has picked up. Do you think that will continue?Yes, I think it will, albeit at a moderate pace. I don`t think we are in store for anything like the feeding frenzy we saw in the summer of `95 or late `97. But I do think we are going to continue to see a relatively steady pace of consolidation. In the immediate term, you have the prospect of the end of pooling-of-interests accounting as a catalyst, so acquirers have some incentive to use that while they can. But, at the same time, what has really stalled out consolidation is that we`ve essentially come through a two-year bear market in bank stocks. They`ve come back this year reasonably well, but the valuations in most cases are well below the all-time highs. So, you have this gulf between the bid and ask prices of the buyers and the sellers. That has started to change. And I think what is really encouraging is that we are seeing a sea change in the nature of bank consolidation in the past couple of years. We are seeing an increasing dispersion in both bank performance and, as a consequence, in bank stock valuation. So banks don`t all have the same multiples. You have high performers being clearly rewarded in the marketplace with higher stock multiples. That gives them a more valuable currency to go out and make deals. These top performers are finally empowered to go out and win bidding contests on a basis that benefits both the buying and the selling shareholders. Whereas many large bank deals have destroyed shareholder value over the past decade, I think we are in the beginning stages of a new era, in which it`s not merely big banks buying smaller banks but, more importantlyu00e2u20ac”irrespective of sizeu00e2u20ac”it`s better-run banks buying less-well-run banks. You have the best managements in the industry managing more and more market share, which brings more discipline to the lending environment and is actually more beneficial to shareholders than some of the consolidation activity we saw in recent years. Do you have any picks or combinations that you like better than others? While I think the overall tenor of bank consolidation is improving for shareholders, the constraining factor is that you have a relatively small population of banks that have proven to the market that they can execute and achieve those superior multiples. You have BB&T and Wells Fargo, which I expect will continue to have a fairly steady diet of acquisitions and will certainly have the potential to do something larger. You`ll have Fleet buying Summitu00e2u20ac”that probably keeps it occupied for a while. Firstar, with its purchase of U.S. Bancorp, is out of the market for the time being. I`m somewhat skeptical because basically you need to see a pairing of one of the higher performers with one of the laggards, a bank like a Summit or U.S. Bancorp whose stock has continued to languish for quite a while now. In that camp, the stock of Union Planters has been a perennial underperformer. Regions Financial also has lagged. With those, if a high performer came along, the deal could prove to be accretive to earnings. But I think there`s not an overwhelming number of those potential possibilities, particularly with some of the most obvious acquirers like Firstar effectively being out of the market right now. You think the better opportunities have been taken? Right. But, of course, it just takes time. A year from now, Fleet and Firstar will have made enough progress to begin looking at other opportunities. |BD|