Banking & Securities

Financial-services companies spent the past five years scrambling to be all things to all customers. Through acquisitions, alliances, and internal growth, they raced to get bigger by entering new business areas. Insurers and banks added higher-margin investment banking capabilities. At the same time, securities firms moved into more traditional commercial banking turf.

But 2001 may be the year the music stops. Rising problem loans and compressed profit margins, combined with slower economic growth, are expected to create a much more challenging environment for banks and securities firms. So in the next 12 months, these firms' strategies could shift into reverse. Executives may still shop for acquisitions. But they will concentrate more on paring down--identifying and nurturing high-performing units, cutting costs, and pruning away dead wood. "You have a lot of uneconomic structures in place," says veteran bank analyst Sean Ryan, formerly with Bank of America Securities. "They may have seemed O.K. at 6% economic growth. But in a more normal environment, the stress cracks become apparent."

Already, signs of strain are showing. UnionBanCal (UB), Morgan Stanley Dean Witter (MWD), and Chase Manhattan (CMB) all have said that their fourth-quarter earnings won't meet Wall Street's expectations. Chase is firing 5,000 of 95,000 employees--60% more than it had planned when it announced its merger with J.P. Morgan & Co. (JPM) in September. The securities unit of insurer Prudential Insurance Co. is closing its investment banking division and cutting 160 employees. And Dutch insurer ING Barings plans to dump its U.S.-based investment banking shop.

FED WATCH. How bad could things get for financial services firms in 2001? As always, it all depends on the economy, says Citigroup (C) Co-Chairman and former Treasury Secretary Robert E. Rubin. "That's where the ball game is going to be," he says. One factor will be the Federal Reserve Board's call on interest rates. A drastic cut could help juice up financial companies' margins, but a smaller one may barely have an impact on profits.

Any slowdown will feel harsh since it comes on the heels of the strong first three quarters of 2000. Despite fourth-quarter profit warnings, securities firms' pretax profits in 2000 are still expected to reach a record $20 billion, on $241 billion in revenues, estimates the Securities Industry Assn. But in 2001, securities firms will have to settle for low single-digit growth, says Amy Butte, securities industry analyst at Bear Stearns Cos. That's down from double-digit growth in 2000.

Paradoxically, the slowdown could also trigger another buying binge. Since 1997, there have been more than 400 mergers and acquisitions of U.S. securities firms. The average price of these deals has grown steadily, hitting $2.5 billion last year. But rather than slowing mergers, a sluggish economy could push outfits hard hit by loan losses or lower profits into the arms of stronger banks and insurance companies and European firms still eager to get into the U.S. "There are still a lot of buyers out there," says Allen Morgan, chairman of Memphis (Tenn.) broker Morgan Keegan Inc. (MOR), which last month was acquired by Birmingham (Ala.)-based Regions Financial Corp. (RGBK) Other potential targets include Bear Stearns (BSC) and Legg Mason Inc. (LM)

Of course, not all banks or securities firms will suffer. But there are serious trouble spots. Increasing loan losses and pressure on profits are raising investors' concerns about banks. Many promised--and delivered--double-digit growth in recent years, in part by easing lending standards. Now, as more borrowers suffer from the slowdown, the likes of Bank of America Corp. (BAC) and First Union Corp. (FTU) are having to raise reserves to cover unpaid loans, thus cutting into profits.

Assuming the economy has a soft landing, Rubin and others expect dud loans to continue to rise. In 2000, loans classified as substandard soared 70%, to 3.3% of all loans outstanding, or $63.3 billion, according to the Federal Reserve. And even with robust economic growth, problem loans would still increase until at least mid-year 2001, according to independent bank analyst Michael Mayo, who foresaw the shakeout a year ago when he was with Credit Suisse First Boston.

Clearly, banks will need to boost reserves to cover the uptick in problem loans. Loan-loss reserves have fallen for the past several years and now represent only 1.41% of loans outstanding--the lowest level since 1989, says Keefe Bruyette & Woods Inc. analyst Thomas F. Theurkauf Jr.

Meantime, profits from plain vanilla consumer deposits--the bulk of traditional bank earnings--are falling. As investment banks and mutual fund companies chase customer assets, consumers are leaving less money in their checking and savings accounts. "The low-cost deposit product is clearly a dinosaur and while not extinct, is certainly an endangered species," says rating agency Fitch IBCA's latest U.S. Banking Quarterly Review.

Revenues from banks' venture-capital units are way off, as well. Many banks saw record profits in the first quarter of 2000, in part because investments in startup technology and Internet companies were performing well. But since then, holdings have fallen sharply, forcing banks to write down their value.

CHASING THE MONEY. The coming year doesn't look any easier for securities firms, either. The industry's big earners to date--megamergers, acquisitions, and underwriting of bonds and equities--are expected to slow. Indeed, underwriting fees from initial public offerings dried up after the Nasdaq tumbled last spring. "Fees and trading profits out of Wall Street will be a little less," says KPMG consultant Robert Arning. Consequently, firms will be looking to increase nontraditional revenue sources, he says.

Conditions will also be tougher on the retail side. To be sure, there are more investable assets than ever before. And the percentage of U.S. households that owns equities has jumped to 48.2% of all households in 1999, up from 32.5% in 1989. But the stock market downturn is slowing the inflow of new money, leaving firms all chasing the same pool of high-net-worth clients. "That's where the money is," says Mark B. Sutton, president of PaineWebber Inc.'s (PWJ) private client group. At the same time, banks are trying to tap previously ignored pockets of the population. The number of households headed by women and minorities with annual incomes of more than $100,000 is expected to double, to 1.6 million, by 2010.

The securities industry faces big outlays. Companies expect to spend a total of $1 billion overhauling computer systems to handle a Securities & Exchange Commission mandate switching stock trades to decimals from fractions. Then they face an $8 billion bill through to mid-2004 on system upgrades to process all their transactions in a single day--as opposed to three to five days now. By contrast, the industry spent $5 billion to brace for Y2K.

The winners will be firms with enough funds for the chase. In a challenging economic environment, firms that spend their dollars most efficiently will be more likely to survive, says Richard H. Repetto, securities industry analyst at Putnam Lovell Securities Inc. He feels most optimistic about companies that have successfully integrated technology into their business models, such as TD Waterhouse Group Inc. (TWE) and Charles Schwab Corp. (SCH) As the borders between banks and securities firms continue to blur, it's going to be a hell of a fight. That doesn't mean big can't be beautiful. But it does mean the big can no longer afford to stay fat.

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