Magazine article The Journal of Lending & Credit Risk Management

Capitalizing on Capital Markets

Magazine article The Journal of Lending & Credit Risk Management

Capitalizing on Capital Markets

Article excerpt

Regional banks are becoming increasingly active in the trading, selling, and underwriting of securities for corporate clients. A survey reveals that they are still struggling to find the most effective way to integrate institutional capital markets activities with their overall corporate market strategies.

During the first quarter of 1996, Furash & Company interviewed the heads of institutional capital markets at 13 of the largest players in this business among regional banks. These banks were a representative sample drawn from banks with $10 to $50 billion in assets. The results of this survey revealed both the promise and the challenge of incorporating trading, sales, and underwriting of securities into banks' approach to serving their corporate customers.

Market Making

A major requirement for active participation in institutional capital markets is the ability to act as a market maker for customers. When a bank decides to make markets in securities, it makes three significant commitments:

1. It is indicating to its customers that it stands ready to give bid or offer prices for the securities it deals in regardless of market conditions or volatility. A bank that fails to honor this commitment (for example, by not making reasonable bids to customers that want to sell securities while markets are dropping) risks serious damage to customer relationships.

2. It has decided to place the bank's capital at risk by holding a securities inventory. While many bank dealers limit their risks in certain products by acting as agents or by matching trades "back-to-back," institutional market makers in liquid instruments with a high degree of price disclosure must carry inventory to be competitive and profitable.

3. By acquiring an inventory of trading positions, it has committed to the bank's shareholders to manage the market risk that goes with holding securities.

The banks in the survey act as market makers in an average of five different products. Municipal bonds and U.S. Treasury securities were the most common products for market making activities, followed by repurchase agreements (repos), mortgage-backed securities, swaps and other derivatives, asset-backed securities, and foreign exchange. When asked whether their trading volume had increased or decreased in the past three years, more banks reported increases than decreases for every one of these products.

The mix of products at the sample banks testifies to the variety of services provided by bank capital markets operations. While municipals provide a tax-exempt investment option for retail customers, Treasuries and other taxable fixed-income instruments are the staple investment of corporations. Repo trading offers short-term borrowing and lending capability to institutions, while swap trading gives customers the ability to hedge and manage cash flow.

Especially noteworthy is the nearly even split of the banks surveyed on making markets in technically complex derivatives and mortgage-backed securities (seven are market makers, six are not in each case). These products offer valuable investment and risk management options that corporate customers demand. But they also require an advanced trading technology infrastructure (for market making and for managing market risk), as well as heightened vigilance over the activities of salespeople for compliance with securities regulations. Furthermore, revenues from these products tend to be extremely volatile. Nonetheless, only two of seven dealers making markets in derivatives said that their volume is less than it was three years ago, and only two of seven mortgage-backed securities market makers have cut back their volume.

It appears that the banks in the survey are split into two factions: One group believes that they must offer derivative and mortgage-backed securities products to corporate customers, and they have come to terms with the risks and the volatility. The second group has shied away from these products but at a cost. Their calls on customers are less complete than those of more aggressive banks and brokerage firms. This shortcoming must be addressed in devising a competitive strategy.

Underwriting

The securities underwriting activities of bank capital markets groups are generally more modest than their market making. The regulatory constraints of the Glass-Steagall Act have certainly played a role in keeping regional banks out of the business of underwriting securities for their corporate customers. But the more immediate impediments to underwriting activities appear to be a lack of institutional distribution clout and, in many cases, a poorly developed awareness of capital markets by corporate lending relationship managers. Nine of the banks surveyed employ fewer than 10 institutional salespersons, and only one employs more than 30. Nine respondents also agreed with the statement, "Our bank's commercial lending relationship managers often miss opportunities to introduce capital markets products to customers."

Underwriting municipal bonds has been a natural outgrowth of banks' local government relationships and retail sales activities, and 12 of the 13 banks surveyed are active in this area. U.S. government agency debentures can also be distributed by a combination of a retail sales force and a small institutional group, and 7 of the 13 banks sampled are active in underwriting this product. However, a modest institutional sales presence and poorly developed corporate finance and structuring capabilities have kept regional banks from becoming a significant force in underwriting corporate, mortgage-backed, and asset-backed securities.

Significantly, several of the banks in the survey want to increase their underwriting activities. Two of the banks already have Section 20 subsidiaries, though neither are underwriters of corporate securities at present. Five other institutions said that they expect to have Section 20 subs within the next three years. It seems that a majority of the sample feels that both offering underwriting services to corporate clients and underwriting products for distribution to institutional investors will be important businesses in the future.

Going forward, these banks will need to identify the level of commitment they want to make to corporate finance. Those that are willing to invest in upgrading their distribution and corporate calling efforts also must be able to offer a full range of solutions to their customers' financing needs. Those that are unwilling to make this investment will be competing for a shrinking percentage of routine financing activities.

Integration

Integrating capital markets with more traditional banking activities, such as corporate lending, cash management, and investment portfolio management, is a critical challenge. If regional banks cannot find a way to serve the capital markets needs of their established customer base, what is their strategic advantage in this business? It is not impossible for trading, selling, and underwriting securities to be profitable activities on a stand-alone basis, but banks are not getting the full benefits of being involved in these businesses unless they establish an organized program to take advantage of cross-selling opportunities. Based on the survey, it appears that this is easier said than done and is a continuing, thorny problem.

The major intrabank opportunities examined involved the connection between bank capital markets groups and the corporate lending relationship managers who generally lead most of a bank's activities with its corporate clients. Bank management appears to recognize the important role a relationship manager can play in introducing capital markets products to corporate clients. Nine of the banks said that their institutions use cash commissions or some other formal program to reward corporate lending officers who introduce capital markets professionals to their clients. Capital markets managers are well aware of the importance of lending calls, too. Ten of them agreed with the statement, "Our bank's commercial lending relationship managers have the power to act as 'gatekeepers' to the bank's corporate customers."

Despite efforts at cross-selling, there is still clearly a long way to go at many banks. While nine banks have formal programs to encourage capital markets introductions, only one of the capital markets managers disagreed with the statement, "Our bank's commercial lending relationship managers often miss opportunities to introduce capital markets products to customers." It is also noteworthy that only five capital markets managers agreed with the statement, "Our capital markets professionals have easy access to customer databases maintained elsewhere in the bank." In other words, the spirit is willing, but the implementation is weak. If executive management does not force, reward, measure, and insist on cross-selling, it will not happen.

The survey found the same mixed record in responses about capital markets synergies with other areas of the bank. Only 6 of the 13 banks reported participation by the capital markets area in structuring loan or savings products (for example, capped rate loans and indexed certificates of deposit). And only two banks agreed with the statement, "Our bank's management feels that our activities as market makers in securities significantly enhances our ability to manage the bank's investment portfolio."

Of course, cross-selling is a two-way street, and capital markets products can attract new customers that become clients of other areas of the bank. But relatively few of the banks in the survey seem to be acting on this significant opportunity. When asked to respond to the statement, "Our bank's management views capital markets as a 'door opener' which may lead to a new commercial lending relationship," four banks were not sure whether to agree or disagree. Only two banks strongly agreed with this statement, while only one strongly disagreed. This response indicates a strategic ambiguity on management's part that can undercut efforts to implement strong integration policies.

Banks appear to have similar mixed views on a more basic question: Should capital markets groups concentrate their efforts on current and potential customers of the bank or should they seek out profitable business wherever they can find it? Nine of the banks in the survey agreed with either the statement, "Our bank's capital markets group is expected to pursue profitable business with customers with whom the bank is unlikely to have other dealings" or the closely related, "Our bank views capital markets activities as a stand-alone business that is expected to produce significant profits on its own." Yet seven of those nine reported that more than 50% of their securities sales are to customers that are also customers of other areas of the bank, which indicates a probable need for more aggressive market development.

Instituting and implementing clear policies that promote integrated calling efforts and cross-selling is a key to success in capital markets. Specifically, relationship managers must not just be trained to understand capital markets products; they must have cross-selling included in their performance measurement and compensation formulas. Management must act assertively if integration and cross-selling is to happen. Anything less will turn out to be disappointing lip service.

Management Concerns

The final section of the survey asked the respondent banks to rank four issues in order of the level of concern to management. The composite rankings follow (with the top two responses in a virtual tie):

1. The ability of the capital markets business to consistently earn adequate returns.

2. Management of market risk in the bank's trading positions.

3. Salespeople's compliance with securities laws in dealing with institutional customers.

4. Threats from new legislative or regulatory issues.

These responses are not surprising. Top management is rightly concerned with risk management and compliance issues, but the goal of being in a business is, after all, to make money. Instituting a strong risk management and compliance infrastructure is a given for any capital markets participant. The danger in management's desire for consistent returns comes when it is not combined with a realization that many areas of the capital markets business are inherently volatile and cyclical. If management weakens the bank's commitment to the business after every poor month or quarter, the bank will not be able to carry out a consistent long-term strategy for growth.

Conclusion

There are certain key areas that bank capital markets groups must address in order to grow and prosper in the future. These include:

Strategic Direction

The banks in the survey fall into two camps. The larger group expects its capital markets business to be able to grow independently of other bank businesses and to seek out new customers wherever it may find them. The smaller group sees capital markets as a complementary pursuit that exists largely to serve customers of other areas of the bank. While there is no "right" approach and either strategy can be successfully executed, it is important for banks to plan and allocate resources appropriately for their goals and to commit boldly to execute the strategy selected.

For the banks seeking stand-alone profitability, components of an effective business plan should include:

* An emphasis on market development and targeting new customers.

* Development of specific niche product offerings that appeal to a sufficiently broad spectrum of middle market investors.

* Selective investment in the technology and personnel required to compete with larger brokerage competitors in these niche areas.

* Using the corporate customers of other areas of the bank as a base from which to expand.

The key is to develop the skills and structure to compete with anyone for business with targeted customers in selected product areas. To do this cost effectively requires careful focus on the customers and products for which regional banks can develop a competitive advantage. For the banks that view capital markets as a complementary service for their other customers, business plan considerations should include:

* Developing incentive structures to encourage the introduction of capital markets products to lending clients.

* Educating lending, cash management, and investment professionals on capital markets applications that can help them in their areas.

* Deciding to what degree business with counterparties outside the banks' customer base and geographic area is necessary for effective market making and distribution.

Integrating capital markets services with the other activities of the bank is a major concern for these institutions, as is maintaining a critical mass of business. It requires a management imperative to share customers - a demand that everyone "get with the program."

Risk Management

Profits from trading and selling securities are measured in small fractions of a percent, while losses from inattention to risk management are measured in millions of dollars. Whether it involves analysis and hedging techniques for trading positions or attention to compliance rules in educating salespeople, establishing the proper organization, measurements, communications, and management disciplines for a comprehensive risk management system is absolutely essential for a capital markets business. Institutions that skimp in this area risk not only millions of dollars of direct losses but tremendous damage to their reputations as well. Dealing with risk is at the heart of being able and willing to be aggressive and committed to capital markets. Without it, a bank sends timid signals internally and externally about its commitment, which, in turn, undercut its ability to succeed.

Integration

Whatever the strategy of a bank capital markets group, a bank is not taking full advantage of its capabilities if cross-selling and integration are not management priorities. Top management must take the lead in eliminating counter-productive conflicts and turf battles. Professionals in other areas of the bank must be educated and be given the proper incentives to regard access to the capital markets as an important customer service option, not a competing product. Databases of customer information must be designed to allow access across all a bank's businesses, including capital markets. This type of management commitment will allow capital markets activities to continue to grow in importance at regional banks. Again, a firm handle on risk management and consistent commitment to capital markets are needed to enlist officer support. A lukewarm commitment coupled with timidity regarding product or market risk makes a loan officer unwilling to put his or her career or customer relationship on the line.

Regional banks cannot afford to let their capital markets groups fail because of internal conflicts and timid management. Capital markets services are becoming too important to corporate customers for banks to cede this business to competitors. The banks with integrated strategies, comprehensive risk management, and decisive, consistent leadership will be the winners in capital markets activities.

Edward E. Furash is chairman, Furash & Company, Washington, D.C.

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