The rising tide that lifted the value of all banks is clearly ebbing.
The dramatic increase in bank values during the 1990s was driven by earnings growth coupled with a soaring stock market. At the same time, industry consolidation was being fueled by acquirors using 20+ P/E multiple currencies to buy other banks.
The party started to end, however, when a few high-profile money-center banks and investment banking firms, along with their clients, had some problems in Russia, Asia, and Latin America regarding currencies, debt, and equities. In particular, a few of their more highly leveraged clients guessed wrong on U.S. interest rates, which did not behave exactly as predicted by two Nobel Prize winners.
The resulting devaluation of money-center bank stocks spilled over, as it almost always does, to the regional and community banks. Active acquirors' multiples have retreated, which in turn reduces the multiples they can pay for acquisitions and still have them be nondilutive. Thus, expectations regarding valuations will begin a period of readjustment unless, of course, the market valuations of the acquirors rebound.
What this means is that many banks will be refocusing on increasing earnings-not selling out. To increase shareholder value in 1999, senior bank managements and boards of directors will have to demonstrate an ability to build long-term, sustainable earnings. But the widening impact on bank earnings of global economic developments and rapidly changing financial markets will complicate this challenge.
"The Year of the Lender"
Worldwide economic problems and volatile financial markets affect money-center banks more than other institutions. Those money centers that are major lenders to highly leveraged speculators and emerging countries and that are, in addition, heavily reliant on fee income from investment banking, have a "witches brew" of potential problems. On the other end of the size spectrum, some community banks are starting to experience what may well be the beginnings of longerterm credit quality problems reflecting their local economic conditions.
The quality of credits put on the books, particularly over the past three years, is going to become a critical issue. Many banks will continue to have low loan losses due to excellent underwriting and strong local economies. Today, banks should focus on getting out of loans that could turn into potential problems, especially while there is still time to hand them off to overeager competitors that are still focusing on loan growth, not quality. Clearly, this is not the cycle of the moon to be overextended.
The impact of financial wealth creation
Immense financial wealth has been created in the past two decades. Consumer financial assets have risen from $6.4 trillion in 1980 to $27.1 trillion in 1997, an increase of $20.7 trillion or 223% according to the Federal Reserve. Much of that wealth creation has been tied to a soaring stock market. The big question for commercial bankers is simply this: How would a downward revaluation of financial assets affect your bank's key customers? Carried to the logical next step, what would be the effect on your customers' customers? The best way to look at the stock market drop, or "adjustment" as the Fed calls it, is that major stock market declines are not particularly good predictors of recessions: Of 11 major stock market declines, only five were followed by recessions. Conclusion: beware of commercial business customers who depend on high-end, discretionary spending; embrace those good business customers who meet real, ongoing needs.
Real estate lending and values
Real estate activity and values continue to be supported by a combination of low interest rates and willing lenders. This has been a highly profitable area for most banks. However, keep in mind that real estate is worth the amount of depth it will support plus a little or a lot of equity, depending on the times. Imagine a scenario in which lenders start requiring more equity-values will very likely come down, even in a low interest-rate environment.
A key variable in determining future real estate values will be the willingness of lenders, from banks to institutional investors, to lend money secured by real estate. So, yes, Virginia, there is a Santa Claus, but he doesn't always visit aggressive consumer lenders that make home equity loans at 125% loan-to-value ratios or commercial real estate lenders that financed the last major speculative project in their market. Volatile financial markets
At the end of the day, banking is a reflective industry. It primarily reflects the health of local economies, which, over time, are more or less a reflection of the national economy. No great news there. The convergence of these three variables, however, is assuming greater and greater importance in driving the global economy.
First, the increasing globalization of virtually all economic activity creates booms or busts around the world that have bearing on local economies in the United States. A recent example would be the dramatic drop in the price of basic food commodities due, in part, to decreasing demand from Asia. Weather forecasters have a wonderful way of describing this interrelationship and interdependency: "A butterfly flaps its wings in Bangkok and a month later creates a storm in New York." The scientific name of this phenomenon is "sensitive dependence on initial conditions." Unfortunately in banking and volatile markets, we see it happening every day.
Second, potentially volatile financial markets worldwide are almost seamlessly linked to one another, constantly responding to changes in interest rates, currencies, and equity markets from one time zone to the next, except on weekends. (One solution might be longer weekends with more time for reflection.) The result is that a small splash late at night in one relatively insignificant Asian market can create a ripple that becomes a wave in Europe that by morning, is a tsunami in New York.
Third, and perhaps most important, information about economic activity and financial markets has become universally available on a real-time basis. Not only is the information available, but the world is watching, whether it be a banker viewing CNBC before breakfast or 100,000 traders glued to their Bloomberg screens around the globe. The effect of mass psychology, both positive and negative, on financial markets will likely lead to one thing: increased volatility, whether warranted of not, due to underlying economic events.
We'll soon be characterizing the "good old days" as that time when interest-rate changes were sleep-inducing, currency markets were boring, and stock markets were merely interesting morning reading. The new world of "earnings warnings" instantly sending major company stock prices down has started to make the daily financial news resemble the local evening news-train wrecks being much more newsworthy than the train arriving on schedule.
Perception becomes reality
The intensity of excitement surrounding the financial casino of the nineties simply reflects the fact that, for a while, everyone was winning. Most important from a banking viewpoint is that this growth in wealth has contributed to a strong economy and rising asset values, in turn providing loan demand, income to service debt, and increasing collateral values.
Today, virtually all investors feel as if they are losing money, especially when looking back to the peak market valuations. Of course, looking farther back into their financial rearview mirrors reveals that they have made great progress. For many, it's not a question of whether their economic glass is half empty or half full; it's the fact that the glass is still quite full when viewed over the past decade. But how will they respond in terms of spending and their willingness to invest in their own businesses, with their point of reference being the peak overall valuations on July 17, 1998?
The potential for a deflationary spiral
The question in my mind is, does this drop from the top in stock market valuations create a deflationary mindset that feeds on itself, eventually slowing down economic activity and contributing to the deflation of nonfinancial asset values? I firmly believe that one of the most significant forces driving the economy is the power of perceptions about the future, shaped and intensified by the information age in which we live.
Today the financial media does an excellent job of reporting events and what experts think their impact will be on the future. Unfortunately, the media is mass and the experts are human. Thus, a vast array of opinions are quickly and broadly disseminated and become part of our national economic mindset-at least among those who read a newspaper, or watch TV, or talk to friends. The potential for financial market euphoria-or havoc-is extraordinary. Thus, we may be entering into a much more volatile financial environment, in which the greatest strength of banks will be that they are "banks" in the traditional Main Street sense, not the Wall Street rendition.
Meeting new challenges
To meet the dual challenges of potential credit problems and narrowing interest margins in the new environment, banks should focus on what management can control, especially the following:
Profitable revenue growth-Achieving profitable revenue growth by transforming the bank into a highly effective and competitive sales organization is the numberone priority of virtually every high-performing bank I talk to. Today, major opportunities exist for most banks to increase profitable business from existing relationships. The real winners will be those banks who take advantage of this window of opportunity. Clearly, it is a window, because other banks and nonbank competitors are focusing on those same customers. "Build the relationship or risk losing the customer" is becoming a competitive reality.
Operational excellence-Implementing operational excellence to produce significant cost savings and improved customer service is taking on a renewed urgency. Bankers are finding that achieving significant cost savings increases overall earnings or at the very least helps offset earnings shortfalls elsewhere. In an increasingly price-competitive environment, the bank's cost structure will make the difference between strong or weak earnings performance, which will be reflected in stockholder value. It's that simple and yet that important.
Today's cost savings become tomorrow's cost advantages. The objective should be to focus on improving customer service while lowering costs. Quite frankly, our consulting clients do it every day. Operational excellence requires strong leadership coupled with information, experience, and technology. It takes someone who can select and implement the most appropriate best practices from banks throughout the country. No easy task, but the rewards are significant, and the cost of doing nothing over the longer term is unacceptable to most boards and shareholders.
Credit quality-Anticipating future credit problems will require a greater understanding of the underlying fundamentals, not just the current financials, of each customer's business. The challenge will be to identify the vulnerability of each business to changes in the economy that are beyond the business's ability to manage effectively. Here is a short list: a global recession; the impact of the wealth effect on the downside; lower commodity prices; the ripple effect of a flight to quality on the part of institutional investors; the possibility of deflation in some asset values; and of course, Y2K.
What to do? Tighten credit standards. Don't be hesitant about saying "No" to loan requests when you have any doubts. You may be doing both your bank and your customers a favor.
The bottom line
The key to success will be focusing on the basics of achieving profitable revenue growth, implementing operational excellence, and improving credit quality. And from a stockholder-relations viewpoint, starting to lower their expectations regarding the likelihood of earnings increasing quarter to quarter from here to eternity might not be a bad idea.
[Author Affiliation]
ALEX SHESHUNOFF is the president of the bank consulting and executive development firm, Alex Sheshunoff Management Services Inc., Austin, Texas.
