Dodging Bullets in Pittsburgh

Chaos and a sense of doom surround much of the banking industry these days. Then there’s PNC Financial Services Group, the Pittsburgh-based company that has defied the odds with its decidedly strong performance. True, the $142.8 billion company has been forced to tighten its belt like everyone else when it comes to credit quality and provisioning concerns. But the problems haven’t seemed nearly as bad as most rivals’-a testament to PNC’s diverse income streams and its ability to manage expenses and dodge a good chunk of the risks that confront most other banks.

In the second quarter, PNC reported net income of $505 million-up 19% from the previous year; its per-share earnings of $1.45, more or less smashed consensus estimates of $1.16. Rohr, 61, attributes the success, in part, to diversification and strong doses of fee income. The company owns a large processing subsidiary, PNC Global Investment Servicing (formerly known as PFPC), middle-market investment bank Harris Williams & Co., and a 35% stake in BlackRock Inc., a powerhouse asset manager. Cost cuts, many initiated by employees, have been important, as well.

Perhaps most notable has been PNC’s risk profile. The company never was a big subprime mortgage player, and it shows in the numbers. Net charge-offs in the second quarter were .62% of loans, while nonperformers accounted for 1% of assets-both well below industry averages. “We’ve managed the bank for the long run for many, many years now,” Rohr says. “And we’ve managed the risk better by not being involved in businesses with low, risk-adjusted returns.” The icing: As clients seek stability amid the turmoil, PNC has had strong loan and deposit growth. Investors clearly like the story. At a recent share price of $72, PNC was trading at 13.7 times projected 2009 earnings-one of the industry’s highest multiples.

It wasn’t always this way. Back in 2002, PNC was the industry’s poster child for post-Enron reforms. The Securities and Exchange Commission investigated the company for improperly moving some troubled assets off its balance sheet. Rohr, who was named CEO in 2000, initially fought back, relying on opinions from his lawyers and accountants that the asset shuffling was valid. Regulators clamped down, the share price fell, and some shareholders called for his head. Eventually, Rohr consented to an administrative order, acknowledging an overstatement of income and paying a $120 million fine.

All that’s ancient history today. Bank Director recently talked with Rohr about the roots of the current crisis, how PNC is managing through it, and what his board is doing to prepare for the future. This is an edited transcript of that conversation.

What’s your take on what has happened to the industry over the past year?

If you look at the losses, we clearly had a number of people who didn’t look at risk-adjusted returns. If you did, you’d be happy with your balance sheet today-even if you got the risk wrong by 15%.

Somebody told me a long time ago that someday you’ll meet your balance sheet, and when you do, you’d better like it. Over the past five years, no bankers met their balance sheets. Subprime mortgages were originated through a broker, sold to an investment house that packaged them in a CDO with stuff from elsewhere, wrapped with an index or whatever, broken into tranches and sold to somebody in Germany. There was so much liquidity in the marketplace, [and] the velocity of money was so extraordinary, that you really didn’t care what you bought.

The result was, you saw subprime grow from 3% to 23% of the mortgage business. The idea was that whatever you bought could be sold to someone else. And then suddenly you couldn’t.

So today we’re all getting the opportunity to meet our balance sheets. At PNC, we’re just fortunate that ours was protected. We’re not immune to all these things, but clearly, on a relative basis, we love our balance sheet.

Talk about PNC’s approach to risk management.

We have an asset-and-liability management system from BlackRock that helps us with our planning, but that’s [just a small part] of the formula.

Everyone in this company is accountable for three things: teamwork, customer satisfaction, and risk management. The idea is that you can’t put in place a chief risk officer who will catch everything if people don’t care. All the way up the company, you’re engaging different types of risk, so everyone has to be involved.

That includes directors. When we talk about LBO loans, for instance, management sets the limitations, and the board reviews and discusses what is the right level. We also talk with the board about our risk-adjusted return guidelines for large credits and relationships.

Where has that left you today? We hear a lot of talk about a “flight to quality” among clients in the current environment. Are you seeing evidence of that?

One big thing is, we aren’t distracted very much by subprime risk. Our residential housing portfolio is one of the smallest in the industry, and while we’re not immune to the storm, our nonperformers and charge-offs are at roughly half the industry average.

When you’re trying to work out of a large troubled loan portfolio, that’s what gets your attention. We don’t have those kinds of distractions, which has allowed us to invest a lot in technology and new products, and to continue calling on customers and trying to cross-sell them.

As a result, we’ve been winning a disproportionate share of new customers. We’ve added 23,000 new households on the retail side, versus 5,000 a year ago. Our new client acquisitions in corporate banking are up 30% year-over-year. Our treasury management business and electronic health-care payment business are growing by leaps and bounds. PFPC-Global Investment Servicing we call it now-has added more customers than ever this year.

The sales engine across the company is going well-all of our markets are over plan saleswise this year. That’s not normal in this environment. It’s very encouraging.

Fee income obviously has been an important part of PNC’s success. How has the crisis affected your fees?

It depends. Generally speaking, our consumer fees have done well. Harris Williams has held up well in the M&A [advisory] space-it’s down a little bit, but not much. PFPC has continued to grow by adding customers, even though some of the pricing is tied to market levels.

Some pieces have been impacted negatively. Take an area like private banking, where a higher percentage of revenues is tied to market levels. We’ve been able to grow customers and income there, but the market has cut some of those fees back. It’s the same with merchant servicing. We’ve been able to grow customers and transactions, but the dollar volumes are down. That’s simply a reflection of the consumer not spending as much.

But the core notion that fee income will help even out the tough spots in a tough credit environment is working?

Yes. It’s working very well. The average bank gets about 65% of its revenue from net interest income; for us, it’s less than 50%. A bank in that 65% range is really in the credit space and dedicated to yield curve management. We don’t have to play as strongly in those areas, because of the fee component.

We’ve thought all along that having diversified revenue streams was a risk-management advantage; that you wouldn’t have to bet on credit as heavily-or bet on the yield curve as much-as someone whose business is credit-oriented. That’s proven to be true.

What’s your take on the present economic environment?

There are really two economies out there. [Government economic data] indicate that growth was better in the second quarter than people thought it would be. If you ask the technology people, the health care people, exporters, or the commodities traders about a recession, they don’t know what you’re talking about. Life has never been better for them. They’re selling steel at $1,600 a ton. Steel hadn’t hit $250 a ton for 20 years. So it’s the same plant, just an extra 1,400 bucks. That’s not bad. Those people are doing extremely well.

Then you talk with someone who is in residential housing, or is a supplier to the residential housing business or to the auto business, and they’re not just in a recession, they’re in a depression. So you have two different worlds. We can see quality customer growth, because a lot of the economy is doing well.

What does the crystal ball say about the near-term future?

We’ve done an analysis, comparing today’s situation to the 1989-90 real estate crisis. Back then, it took about 18 months after foreclosures peaked for housing prices to bottom out.

This is more or less following the same pattern. Foreclosures are still rising. The number of troubled small banks is rising. [Federal Deposit Insurance Corp. Chairman] Sheila Bair has pointed out for three years that many small banks have as much as four to five times their capital tied up in real estate loans, and now they’re feeling it.

We’re going to have to go through a sorting out of the small banks that are concentrated in real estate. That’s really when residential housing prices will bottom. And then we’ll start to come back.

For now, you just have to be careful, because housing prices could go down another 10% to 20%. As an industry, we’ve written off $520 billion of subprime risk so far. That’s a lot of money, and there’s more to come.

So you’re saying the industry won’t really get out of this until 2010?

Yeah. It might bottom in ’09, and start coming back a little bit. But it’s going to be a tough market housing-wise right into 2010.

But you are optimistic about the commercial side?

Yes, so far the commercial business has been quite good. Even with real estate, most problems are residential, not commercial, from what we can tell at this point.

Has this crisis changed the definition of success and how it is achieved?

The definition is still the same: Grow earnings per-share and have good returns on your capital. But how you get there has been redefined. Some of the methods by which the financial services industry made money in the recent past clearly have to be rethought.

Can you give an example?

For the last five years, leverage has been the way many people have achieved success. We’ve had tremendous liquidity, and whether you’ve leveraged LBO loans at five to seven times capital, or you’ve leveraged off-balance-sheet structures or CDOs or CLOs, or made a lot of money through fixed-income syndication, those products and capabilities probably won’t come back in the same way as before-at least not in the near term.

Are you seeing new winning strategies as a result of what’s happened?

The traditional business is better than a few years ago, when people created off-balance-sheet structures to generate a higher return on capital.

Now much of the industry is going backward. Spreads are much wider. For the first time in a long time, you can make loans, hold them on your balance sheet, and get a reasonable return. It’s about putting the assets on your books if you have the capital available.

Do you anticipate any acquisition opportunities emerging from the crisis?

Yes, but you have to be cautious.

Investors and analysts are looking at our share price relative to other banks, and asking if we’re going to go buy somebody. Our response is that we think housing prices will continue to decline, and that means losses will be greater on certain portfolios. It’s very difficult to look inside a bank and see the true quality of its balance sheet. So we don’t feel in a hurry to do a deal.

Would you entertain the notion of buying a troubled institution with FDIC assistance?

It would depend on the terms and conditions. But if you’re looking at a transaction where the FDIC is taking out much of the risk, then it has the potential of being a good opportunity.

PNC is regularly named one of the top 100 technology companies by CIO magazine. Talk about some of the innovations in the pipeline.

We’ve got a virtual wallet retail product that’s really taken off. We actually hired an industrial design firm to help us study how younger people behave and how they live differently. We went into their homes, and we went to Korea and other countries and looked at how other people use technology.

And then we built this product that allows you to populate a calendar with your paydays and your dividend days and your bill pay. The calendar will notify you-on your phone if you want-on your ‘danger days’ when your accounts might be low. So you can go right online, see your balances. It’s a checking account, a bill pay account, and a savings account all rolled into one, and with a very high-tech touch that’s really unique in the industry.

It’s new, but we’ve got 15,000 people viewing our online pages for virtual wallet every day and are opening 200 new accounts a day. People like it.

What else is working well?

We have a remote deposit product for small businesses. Those customers used to have to bring their deposits into the branch. Now we just put a little remote deposit capture device in their offices. They can run the checks through and we can take the deposit electronically, without them having to show up physically at the night-deposit window. That’s taking off like gangbusters. It’s a convenience thing.

Our treasury management business has grown double-digits, as opposed to low-single-digit growth for the industry, because of the technology we’ve invested in. We manage customers’ receivables, and update them daily with an online interface. It’s relatively unique-a couple of other banks do it.

And our Healthcare Advantage product allows us to go into hospitals and actually help facilitate electronic payments. We only have one competitor in that space.

You also have a mobile banking application. There continues to be a buzz about mobile banking. Does it have legs?

Absolutely. The jury is still out on how many things people will do with mobile banking. Would you check your balance? Absolutely. But today you have a difficult time making a person-to-person payment on a phone. That’s a problem.

Even so, we think that with time, it’s something these young kids will do. The phone is such an appendage for them. I knew my daughter was home the other day because I saw her phone sitting on the table. I knew she had to be within a room or two, because the phone is such an integral part of her life.

As you watch the evolution of hand-held technology, it’s kind of amazing. The applications we see today will be very different in a year or two.

How else does PNC get an advantage from technology?

Cost-cutting is the key to the M&A business. And we’ve been able to take out, on average, 40% of the costs of an acquired bank based on our platform and technology.

In-house, we entered into our One PNC effort. It’s since evolved into a thing called ‘Continuous Improvement.’ That’s been worth more than $500 million in cost savings, pretax. We have employees contributing things to the process all the time. That’s an ongoing thing to improve our operating leverage, where revenues are growing faster than expenses.

The key to ONE PNC has been getting employees to suggest areas that need improvement?

Yes. We had a basic premise that employees were not allowed to present an idea that injured the customer. And they were able to find a heckuva lot of things that we did that were redundant or that customers didn’t appreciate or that we spent too much money on it. When we implemented it and took out 3,000 positions, customer satisfaction went up. It shows that employees know better than you do where you’re wasting time and money.

How involved is your board in PNC’s innovation process?

We have a very active board. It’s a very diverse group, with people from all walks of life. We have technology people on the board. We have marketing people, international people. It’s not at all Pittsburgh-centric. They’re involved in everything we do.

Every spring we have a strategic planning meeting. Each of the businesses makes a presentation to the board, and then we have a very interactive question-and-answer session. It goes from, ‘How are you doing financially?’ or ‘What are the product trends?’ to what new products are on tap, what capital expenditures will be required, and the growth trajectory into the future. We use a three-year time horizon. Some banks use 10 or 15 years; I can’t figure things out that far.

How deep do your directors get into the minutiae of new products?

They get into the details to see how it works, but they are not involved in development. When we bring a product to board members, they have questions about the roll-out-how broad the roll-out will be, whether it will be applicable inside or outside our footprint, what the advertising spend is to promote it. They ask a lot of high-level questions.

Do they approve specific investments for those product initiatives?

No. We’ll come to them every year in January with budgets for each business. Those projects are imbedded within the business’s budget for the year.

We hear a lot of talk about how bank board members are working harder in today’s environment. What has changed for your board in the past two years?

Well, I think our board members are happy to be on our board (laughs).

We’re in the middle of a hurricane. A half-trillion dollars of losses in the financial services industry is a hurricane. We’re not immune to it. We’ve spent a lot of time with the risk committee, figuring out where we are. We’re modeling things getting worse from here.

The good news is, we’re a very, very liquid bank. With an 86% loan-to-deposit ratio, we’re as core-funded as anybody.

Did the regulatory issues PNC experienced in 2002 leave you better prepared to manage through the crisis?

The previous regulatory issues we had centered around one accounting entry seven years ago. It was not around credit quality, it was not around interest rate risk. It was around a difference of opinion between our auditors and the Federal Reserve on an accounting entry.

Even so, you dealt with the regulators quite a bit. Are there any insights you gained from the experience?

What I’ve learned is that they are your partners to a great extent. There’s nothing really in it for them if you succeed, but it’s bad for them if you don’t succeed. So they don’t want you to fail.

We have very good relationships with our regulators today. They’re ultimately in the safety and soundness business. And if you’re not safe or sound, you’re not able to help your shareholders. If you look at things that way, they can be very helpful.

Does the industry see lasting change out of this crisis, or in two years will we be back to the old ways?

People won’t forget this one for a while. You’ll see the industry being much more diligent in risk management. A number of the fixed-income markets won’t come back to where they were for the foreseeable future. Leverage will be questioned and managed much differently than it was in the past.

I also think there will be some regulatory change over time. The regulatory system was set up 75 years ago. Clearly the markets have gotten more global and complex. The Fed is sophisticated enough [to oversee them]. But you have things like hedge funds and derivative markets-different players in the market that aren’t really covered by the regulatory environment. That makes managing systemic risks more problematic than in the past. So there will be an evolution of our regulatory structure that will be more complete in terms of filling the gaps that have emerged.

What lessons can directors find in the current crisis?

This is a major time of change that’s quite frankly very painful for the industry. What strikes me most is that we’re in a very long-term business, where you can lend money to someone and not know if it’s a good idea for three years. So boards have to help grow their customer bases as best they can and guard the balance sheet on a risk basis every day. At the end of the day, that’s what it’s all about.