The Future Of Banking


Want a revealing glimpse at the future of banking in America? Consider the tale of Stephen D. Nygren. In 1973, the Atlanta businessman and a partner scraped together their savings, got a $25,000 loan from Trust Co. of Atlanta, and started the Pleasant Peasant, a trendy eatery. The new business was a smash. But cautious local banks refused to finance expansion beyond the first two locations. "We had to find a way around the tyranny of the banks," Nygren recalls.

So in 1988, Nygren found an equity partner, New York-based Quantum Restaurant Group. The ultimate source of Quantum's funds? A partnership dominated by the likes of Prudential Insurance Co., corporate pension funds, and foreign investors. With Quantum's help, Nygren now manages 19 restaurants in Atlanta and Washington, with annual sales of $20 million.

Nygren and thousands of other business executives have come to understand what Congress and the Bush Administration are just beginning to grapple with: The banking industry, at least as we know it, is dying. Constrained by a welter of regulations, banks are losing their most lucrative markets. This has helped push many of them into a frenzied search for merger partners as the industry tries to reduce its costly overcapacity (page 77 41 ).

MINOR PLAYERS. Numerous less-regulated nonbank competitors such as General Electric, Sears Roebuck, General Motors, and American Express now offer a wide array of bank-like services. Corporations, aided by Wall Street, are selling ever-greater volumes of commercial paper, which has cut into banks' short-term corporate borrowing business. Commercial credit firms and insurance companies are actively providing long-term financing. And money market funds, which offer better yields than certificates of deposit, have lured away a large share of banks' deposit base. "Banks in the traditional form are already obsolete," says George J. Vojta, chief strategist at Bankers Trust Co. "If you conduct business in accordance with the legal definition of banks, you won't survive."

Banks may retain their domination of a few niches such as small-business lending and check clearing. But eventually, most of today's banks will be just another set of participants in a financial services free-for-all where everyone will be able to invade rival turf. The leading figures will likely not be sprawling financial department stores but highly successful niche players. The chief beneficiaries will be borrowers, savers, and investors, who will have access to a wider range of services at lower prices.

The decline in banks' dominance of finance has been stunning. In 1974, 37% of all financial-institution assets were held by banks. By 1989, they had lost a quarter of their share as their slice of the market plummeted to 27%. Even in their core business--short-term corporate lending--banks' share slumped from nearly 80% in 1975 to about 55% in 1989.

Especially telling has been the damage to the bottom line. Bank profitability has been declining for two decades. In 1989, according to banking consultant David C. Cates, the 10 largest finance companies earned their shareholders a 12.7% return on equity; their biggest bank competitors earned a paltry 0.4%.

The combination of regulation and deposit insurance is a major cause of the banks' troubles. Federal deposit insurance has long permitted banks, even badly managed ones, to attract funds more easily than nonbank rivals. Yet, the commercial paper market and other nonbank lending facilities siphoned off some of the best lending business. Meanwhile, banks have been prohibited from selling many popular financial products such as insurance and mutual funds. Banks found themselves increasingly tempted to boost shrinking profits by investing deposits in high-margin, but risky, loans. Their portfolios became crammed with Third World debt, financing for leveraged buyouts, and loans to bankroll real estate developments.

Largely because of a passel of bad commercial real estate loans, banks earned a miserable $16.6 billion in 1990 on assets of $3.4 trillion. Hundreds of banks have failed, which has gutted the government's bank insurance fund. The fund is seeking an infusion of at least $70 billion.

The banks' sagging fortunes have renewed debate in Washington about how to smooth the transition of the financial services industry into the 21st century. The Bush Administration has proposed an overhaul of the banking laws that would free the industry from many of its regulatory shackles and reform deposit insurance. "We must modernize our banking laws to deal with the reality of the marketplace," declares Treasury Secretary Nicholas F. Brady.

Far broader changes in deposit insurance than those effered by the Administration are required. Coverage should be sufficiently reduced so that the banking industry would be exposed to stronger market forces in attracting deposits. That would tend to weed out weaker banks and strengthen the survivors.

Virtually everyone agrees the status quo isn't working. "Without reform to deposit insurance and bank regulation," says W. Lee Hoskins, president of the Federal Reserve Bank of Cleveland, "banks will slowly disappear from the financial landscape as unregulated firms take more and more of their business."

The Treasury's reform package, though, is unlikely to get far in Congress this year. Many banks are not waiting. Several money-center banks are seeking to make significant inroads into Wall Street's investment banking turf. Others, such as Banc One Corp. in Columbus, Ohio, are reinvigorating their branch networks. These banks see the industry's unparalleled distribution system as ideal for selling consumer products. Many banks are poised to sell everything from insurance to mutual funds when the law allows.

These moves, though, are doing little to offset the broad erosion in banks' core franchises. Most serious is the damage to their once lucrative commercial-lending sector. Banks now face such formidable rivals as Teachers Insurance & Annuity Assn., the nation's largest private pension fund, which has lent nearly a quarter of its $50 billion portfolio directly to corporations.

Even the phone company is jumping in. American Telephone & Telegraph Co.'s seven-year-old finance unit, AT&T Capital Corp., already has $5 billion in assets. And it's not just financing the sale of telephone equipment. It is bankrolling aircraft and automobile leasing, energy cogeneration projects, and broadcast acquisitions.

A FLOOD. Some of the nonbank lenders, to be sure, have not been immune to the sort of poor credit decisions that have waylaid banks. General Electric Capital Corp. and Westinghouse Credit Corp., for example, recently wrote off hundreds of millions of dollars in bad loans. Yet nonbank executives still feel they have a big edge. "Large industrials like AT&T and General Electric have more credibility because there's a crisis of confidence in banks," declares AT&T Capital Corp. CEO Thomas C. Wajnert.

Consumer lending, another of banking's very few remaining remunerative niches, is also under attack. These days, credit cards make up 30% of all consumer borrowing, aside from mortgages. But banks are rapidly losing their grip on this business to aggressive competitors such as AT&T's Universal Card and Sears' Discover Card. In its first 12 months, AT&T signed up 8.5 million cardholders, and more applicants are flooding in.

Many bank loans, such as credit-card receivables, are being packaged into actively traded securities, which poses long-range competitive problems for banks. Securitization has been made possible by the increasing availability of credit information in computer-managed data bases, which permits the creation of packages of loans with predictable risks.

Although Wall Street firms underwrite and trade these securities, banks have been major participants in securitization. They earn packaging fees. And they can get the loans off their books, making room for new loans. "Securitization will continue to expand," says Bankers Trust's Vojta. "There will be no such thing as a long-term holder" of loans.

Yet by permitting lenders to originate and quickly dispose of loans, securitization makes it much easier for nonbanks to enter the lending business. Look what happened to savings and loans after financial wizards figured out a way to pool home loans into the now-ubiquitous Fannies, Ginnies, and Freddies. Half of all home loans are financed with mortgaged-backed securities. That has lured banks and other lenders into the mortgage business, which has helped erode the thrifts' reason for existence.

Foreign banks are a further threat to U. S. banks. Dallas-based Oryx Energy Co., the nation's largest independent oil and gas company, ended up relying heavily on foreign banks in 1990 to handle what should have been a simple deal. Oryx needed to borrow $1.8 billion to buy back a large block of its stock, but U. S. regulations curbing loans for highly leveraged transactions scared many domestic banks away. "Many of America's banks are either unwilling or unable to participate in providing the financial fuel to Corporate America," says Oryx director and former banker, Charles H. Pistor Jr.

Banks' easy access to deposits is being endangered by a growing number of nonbank competitors that offer higher yields and better service to investors. Money funds now hold nearly 15% of traditional bank deposits. Nearly all of these funds allow limited withdrawals by check. As regulation eases further, money funds could become as accessible as any checking account, possibly offering 24-hour telephone access and automatic teller links.

EYES AND EARS. Baltimore-based T. Rowe Price Investment Services Inc. is typical of the mutual fund companies that are eating into banks' traditional client base. Its money funds hold about $6 billion of what once would have been bank savings accounts, up from $1.4 billion in 1980 and $2.4 billion in 1985. In April, the average yield for taxable money market mutual funds was 6.2% vs. 5.5% for banks.

Funds can offer these yields because they have a clear cost edge. The mutual fund company's overhead is 80~ a year for every $100 in assets, according to Price President James S. Riepe.

Bankers, who must pay for multiple branches and tellers, run up expenses relative to deposits that often are three times higher.

Even the most treasured function of banking, its role as a key instrument of monetary policy, no longer seems as assured as it once was. Historically, banks have been the eyes, ears, and arms of the Federal Reserve. The Fed creates money by feeding reserves--the raw stuff from which loans are made--into banks. As lender of last resort in a financial crisis, the Fed uses banks as its conduit.

But critics say banks are falling down on the job. Witness the current recession. Despite repeated interest rate cuts by the Fed, banks still are curtailing commercial lending, which has made it more difficult for the central bank to end the credit crunch. Banks "created a tighter monetary policy than we intended," Fed Chairman Alan Greenspan told Congress.

The Fed, though, has monetary tools that don't involve banks. More important than setting reserve requirements is the Fed's ability to inject or withdraw money from the system by buying and selling government securities. At some point, the central bank might be tempted to invite other players, such as commercial credit companies and mutual funds, to join the payments system and open reserve accounts. "If somebody took away banks and we had to find another way to create monetary policy, we'd devise another system," says a senior Fed official. "It's not impossible."

SOARING COSTS. A half-century-old regulatory straitjacket has kept banks from responding effectively to the many challenges they face. Banks are largely barred from the securities, insurance, and real estate businesses. Because their product line is limited, banks can't maximize the benefits of their huge branch networks. Regulation adds to banks' cost structure. They must pay hefty and rising deposit-insurance premiums.

Further, unlike the big finance arms of General Electric and Westinghouse, banks must hold reserves against deposits at the Federal Reserve. And they must be responsive to regulatory oversight. When regulators voiced their uneasiness about the rising volume of LBO loans banks were making, many banks sharply curtailed lending for highly leveraged transactions.

Regulatory reform could go a long way toward making the banking industry more competitive. The Brady blueprint would eliminate many of the barriers that keep banks out of securities underwriting, insurance, and most nonfinancial businesses. What is really needed, though, is a radical overhaul of deposit insurance.

Deposit insurance is typically regarded as one of the banking industry's most powerful competitive edges, as well as a government subsidy to the industry that is costing $20 billion a year. But, in fact it has had a pernicious impact. Essentially, deposit insurance has shielded the industry from market discipline. Since depositors have no incentive to favor one bank over another, badly managed banks, even some near insolvency, have been able to attract deposits as easily as healthy, well-run institutions. Says John G. Medlin Jr., chairman of First Wachovia Corp., in Winston-Salem, N. C.: "Prostitution of deposit insurance over the past three decades permitted and encouraged the deterioration of credit quality, loan pricing, and capital cushions of the financial system." One tangible sign of that: In the last decade, 1,086 banks failed, double the total number that went belly up from 1934 to 1980.

The Brady proposals would limit deposit insurance to $100,000 per person per institution, less coverage than currently available. That would help. But more radical changes are needed to produce a healthy banking industry.

A better approach would be to separate lending from deposit-taking. Federal guarantees would be available only to "narrow" banks, which would be required to invest deposits in the safest securities. Banks could set up affiliates that would be allowed to make riskier loans, as well as enter the now-prohibited fields of securities, insurance, and other financial services. But none of those activities could be funded with insured deposits.

That may sound futuristic. But Hugh L. McColl is already reorganizing NCNB Corp., an aggressive super-regional, along these lines. The chairman of the Charlotte (N. C.) holding company envisions a core bank that takes insured deposits to fund consumer and small business lending. A separate noninsured company would be an investment banker or commercial lender for companies with sales over $100 million.

An alternative would be to leave the present system of deposit insurance in place, but reduce the subsidies. Under this scheme, premiums would be based on the riskiness of a bank's portfolio, forcing banks to make more conservative investments or to accept fewer insured deposits.

Unfortunately, S&L-shocked lawmakers on Capitol Hill appear unwilling to go even as far as the Administration proposal. If the bank reform drive fizzles, policymakers will have blown a major opportunity to bring the U. S. financial system into the 21st century.

While Washington debates reform, bankers have been devising their own reforms--survival strategies they hope will get them into the next century, whatever happens in Congress. One popular approach is thinking smaller. Many of the big money-center banks realize that their dream of being all things to all customers was a costly delusion. New York's Chemical Bank, which is still taking hits from past lending mistakes, is now concentrating on loans closer to home--consumers and local businesses. "For this institution, the era of lending fads is over," says Chairman Walter V. Shipley. "The middle-market client is the single major thrust of our activities."

BankAmerica Corp. recently emerged from a similar transformation. Its disastrous Third World loans and burgeoning costs drove it perilously close to ruin five years ago. Then it pulled back from foreign lending, slashed costs, and concentrated on the lucrative consumer market. With the acquisition of seven failed thrifts last year, BofA's strategy of positioning itself as the preeminent retailer in the West is paying off. Last year, it earned $1 billion for the second year in a row, the first U. S. bank ever to do so.

Other banks are focusing on sticking to their knitting. Most of the nation's 12,000 community banks have avoided the problems of their bigger brethren by concentrating on what they do best, such as small-business loans and consumer lending. Despite fears for their future, community banks are likely to be among the strongest survivors of the ongoing shakeout.

Consider Charles T. Doyle, mayor of Texas City, Tex., and chairman and CEO of five community banks in Galveston County with total assets of $186 million. About 60% of his assets are personal loans, averaging $7,000, for such items as vacations, medical bills, and auto purchases. The rest help finance mom and pop operations, from small retail stores to lumber yards and distributors. "These are high-risk loans--unless you know your customer," says Doyle. "You can call it old-fashioned banking, but it works." Indeed, Doyle's banks earned a return of between 17% and 31% pretax for their shareholders last year.

MANY WINNERS. A handful of the major money-center banks, such as Bankers Trust and J. P. Morgan & Co., have set their sights on Wall Street. They are trying to beat the securities industry at its own game. Starting in 1979 , Bankers Trust unloaded its retail business and transformed itself into a merchant bank serving large global corporations. Now, it offers services ranging from trading and securities underwriting to investment banking advice. Since most loans originated by the bank are syndicated or sold in the secondary market, 70% of Bankers Trust's balance sheet is made up of liquid securities. Only 30% is loans held in portfolio. That's a marked contrast with a traditional bank, where the ratio is reversed.

Still, for all of these innovative banks, there are hundreds of tradition-bound institutions terrified of change. Most are unlikely to survive as the barriers to unbridled competition fall away, either through regulatory reform or market pressures. The survivors, though, will have more room to innovate and expand into now-forbidden markets.

Among the customers of the emerging financial services industry, there will be a few losers--but many more winners. Some small businesses--major beneficiaries of the deposit-insurance subsidy--may see their borrowing costs rise. But many companies, which are now turned away at the bank door, may find it easier to raise the money they need to fuel growth. Savers will enjoy greater choice as well, and those willing to accept higher risks will get greater rewards.

For folks like Atlanta restaurateur Stephen Nygren, in short, the "tyranny of the banks," if everying goes as well as the reformers hope it does, will be replaced by an invigorating democracy.

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