CHICAGO -- Larry J. Gorrell says banks should pursue opportunities to use derivatives and build fee businesses. But he says that banks must also improve risk management if they are to safely traverse new financial terrain.

"I quickly get to the word risk" when assessing the evolving financial services market, says Mr. Gorrell. Absent expertise and controls, new ventures can produce results "that were never intended," he says.

Head of Arthur Andersen & Co.'s worldwide financial markets consulting practice, Mr. Gorrell oversees about 5,000 accountants and consultants who serve hundreds of clients scattered around the globe.

In 1993, his team generated nearly $450 million of consulting revenues, or roughly 14%, of Arthur Andersen's revenues that year.

Mr. Gorrell, 47, has an insider's knowledge that few financial practitioners can match, enjoying privileged access to myriad banks, thrifts, asset management groups, securities firms, futures and commodities exchanges, finance companies, mortgage firms, and leasing companies.

The executive's consulting priorities say a lot about where the banking industry is heading.

Aiming to catch one of the biggest financial waves of this decade, Mr. Gorrell has launched an international derivatives and treasury risk management group, targeting both dealers and end users of derivatives.

Acknowledging the government's expanded influence in the banking industry, Mr. Gorrell this year forged a partnership with Secura Group, the Washington-based consulting firm founded by William Isaac, former chairman of the Federal Deposit Insurance Corp.

In an interview with the American Banker, Mr. Gorrell says banks "still have one of the best franchises on the face of the earth," but he says maintaining that status in a fast-changing market will require constant vigilance.

Q.: What are the key opportunities and issues facing the banking industry?

GORRELL: Banks are gaining expanded product opportunities. They can sell mutual funds. They can get into the insurance business, underwriting, and lots of other things. When interstate banking laws are enacted, they also will gain geographic expansion opportunities.

Meanwhile, they are losing the near-monopolistic ownership of other products -- and on both sides of the balance sheet. All this has been going on for a decade, but the pace continues to accelerate. It puts pressure on management.

It presents challenges in terms of the organizational and operating structures required to support a successful pursuit. It presents strategic issues.

Maybe it's my auditor background, but I quickly get to the word risk when I think about the environment.

And I think some of the constituencies bank management has to respond to also quickly get to the word risk, whether it is the board of directors, the investment community, or whether it is the regulatory apparatus.

Q.: What is your take on the banking industry's growing use of derivatives?

GORRELL: Derivative instruments are effective risk management tools, and they are improving as a result of the creativity of the people in that business.

Derivatives will become much more commonplace, better understood, and much more widely used.

They are no scarier, if you will, than loan contracts, and they should become almost as routine as debt agreements.

But if the instruments aren't managed by people who understand what they are doing, if management doesn't get good information about how they are being used and controlled, the result can be things that were never intended.

We believe there are lots of financial and nonfinancial institutions that may need help with these issues, beginning at the top of the organizations.

Q.: Where do we stand on derivative accounting standards?

GORRELL: The question is, how do we report on the financial statements an activity that responds to short-term market events when some of the assets and liabilities it may hedge are carried at historical cost? There is not a crisp solution.

We need to get some agreement on what should be disclosed, so as to assure reporting consistency.

And I think disclosure should focus on use of derivatives, and the outcomes, rather than on mere product types. Once we know what they are being used for, we can wrap up whether we've got the accounting right.

Users of financial statements should be able to discern whether a reporting entity uses derivatives, how they are used, and what accounting methods are used.

Q.: In a recent speech, you warned that lending problems might resurface in the banking industry. What is your outlook?

GORRELL: Certainly banks have tightened underwriting, dealt with problems, and built the strongest capital and reserve positions seen in a long time.

But what is happening now? The economy is beginning to turn, and grow, and credit granting is being loosened. That's all fine. But it does raise questions. What are the odds that we will see growth for growth's sake, that we will have banks looking for loan growth in places they should not look?

I am not forecasting a huge credit problem. But I am saying one ought to be aware of the situation.

Q.: What's your take on the fee side of the business?

GORRELL: Banks recognize there are diminishing returns in building ever-rising levels of capital against balance sheet assets.

So their pursuit of less capital-intensive, fee-based businesses is aggressive. Banks will look, and push, for fee revenues.

And I think there are some bright spots. For whatever we've said about the difficulties and challenges, banks still have one of the best franchises on the face of the earth.

They are still seen, by consumers in particular, as the best place to go for certain products and services. Banks will work hard to take advantage of that fact.

But nothing in life is free of risk. Look at the mortgage business. A year ago we had huge mortgage volume and fee revenue.

Now you've got mortgage bankers, with all this underutilized apparatus, facing two issues: How do I roll back my apparatus, and how do I put as much volume through the system as possible?

Well, pricing is a way to put volume through the system. And there are lots of questions about whether pricing in mortgages today is sustainable.

So in fee businesses, just as in lending, there is potential to make decisions that you will regret later.

Q.: What attitudes and actions are you seeing from regulators?

GORRELL: Regulators are not going to sit on the sidelines and do nothing. They have moved from after-the-fact examiners to becoming much more proactively involved in the business. They are more likely to respond as banks do things, and to try to modify behavior if they are not happy with what they see.

As for banking law itself, The Federal Deposit Insurance Corp. Improvement Act is one of the biggest regulatory expansions banks have ever had to deal with, and I think it has imposed a significant burden.

There is a competitive disadvantage to dense regulation, not because product offerings lose quality, but because the costs of products rise. Customers and shareholders are affected.

Q.: How are banks coping?

GORRELL: Some organizations have done a good job of institutionalizing laws and regulations, incorporating them into their basic processes.

Thus integrated, regulation becomes subject to the same re-engineering as any other process: How do we make it better? How do we get more out of it? How do we reduce the cost of it?

Not to minimize the discomforts and excesses of regulation, but some banks still have a ways to go in assimilation.

If regulatory compliance remains a discrete activity, it will not be institutionalized and accepted into the culture.

That hampers efficiency, and by extension, competitiveness, and it limits the risk management benefits banks can extract from the compliance process.

Q.: Does banking have a future?

GORRELL: You bet. The issue is what changes will unfold in the roles and responsibilities of [financial] intermediaries. Who will try to get into the business, and what role will the government play in shaping the market?

I am encouraged by some things happening in Washington with regard to the banking industry, but the question is whether lesser-regulated entities, such as General Electric and General Motors, will gain the advantage.

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