Magazine article The Journal of Lending & Credit Risk Management

Strategy Pays

Magazine article The Journal of Lending & Credit Risk Management

Strategy Pays

Article excerpt

During the next five years, banks must make the transition from traditional banking organizations to bank-based financial services companies. This change requires that each bank set its own business mix and tempo to achieve its transition, since the new financial services companies will have a wide variety of business mixes. While the need for transition is generally known and accepted, most banks are concerned about the pace required for restructuring and how to determine their new business mix. Pace and mix are affected by two factors: the speed with which traditional balance sheet deposit intermediation businesses will continue to decline and the degree to which the stock market will give banks an opportunity to execute a restructuring strategy in the face of pressures to maintain earnings or to realize shareholder value by selling out.

In other words, will the stock market pay more for focusing on short-term earnings improvement in traditional banking businesses - usually through cost cutting - or be patient and reward longer term strategic restructuring? The logical answer is "both." But there is evidence from bank stock performance in the past five years that this seemingly impeccable logic is not entirely the case. The evidence demonstrates that investors reward cost cutting most when it does not damage the capacity to generate revenue and that they reward strategic restructuring and migration to a new business mix even more.

Thus, achieving a lower cost structure in existing businesses is essential - a basic parity fact of competitive life. But executing a strategic restructuring - whether boldly or by steady migration - is what really pays. In effect, the next five years are a perilous period in which it appears that investors will reward lower cost structures but only if they are used to provide the basis for ensuring imaginative restructuring of business mix. This restructuring is a high-wire act, at which many banks will not succeed, but those that do will be rewarded handsomely.

Longevity of Intermediation

The intermediation process continues to move out of banking and into the securities market as seen in Figures 1 and 2. There is no reason to assume that this trend will change and a better assumption is that this shift in intermediation activity probably will accelerate. Bank response to this earnings challenge has been varied:

* Some choose to migrate rapidly to off-balance-sheet investment or merchant banking activities.

* Others stress loan volume origination that they can securitize and then manage for a fee.

* Still others emphasize continued deposit intermediation by cutting costs, merging with cheaper deposit sources, and underwriting loans that in the past would have been seen as too risky.

Rebalancing Revenue

In addition to these responses, banks are diversifying their revenue sources into capital markets activities, such as trading, derivatives, foreign exchange, and merger and acquisition advisory placements; fee-based services, such as mortgage banking, investment management, and card processing; or market-funded intermediation, such as consumer and commercial finance.

Rebalancing bank revenue streams - from balance sheet deposit intermediation to fee-based and market-funded margin businesses - has been painfully slow and difficult. Replacing a 4% balance sheet lending net interest margin with a 1% management fee for originating and supervising securitized assets requires generating several times more volume. It takes time to do this. Today's highly successful securitizers started building their origination machines years ago. And building a killer category fee business takes either time or the deep pocket for major acquisitions. Thus, replacing declining balance sheet intermediation income is a perilous journey, but it is the key to future strategy.

Cost Cutting

Most banks have begun their journeys with tough-minded expense reduction. …

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