The flurry of merger activity between U.S. banks and securities firms trumpets what has become increasingly clear in banking and financial services: Commercial banks must now operate in a world dominated by competitors with a universal set of lending and capital-raising products.

The relaxation of Glass-Steagall rules and the de facto convergence of financial services capabilities is rapidly causing huge changes in corporate banking strategies, capabilities, and models for relationship management, particularly in the middle-market arena.

This inter-industry consolidation trend has materialized over the past two years with the relaxation of section 20 underwriting restrictions. Today, Chase Manhattan Corp., NationsBank Corp., and J.P. Morgan & Co. are regularly in the ranks of the top 10 U.S. debt underwriters. Increasingly, banks with these section 20 powers are targeting their capabilities to growing, middle-market clients.

Traditional credit is becoming disintermediated as these relatively high-growth, capital-hungry clients enjoy earlier, low-cost access to public capital markets products. These include high-yield debt, asset securitization, private placements, and common equity.

Emerging and middle-market companies are tapping the capital markets with increasing frequency and great success. According to a Booz-Allen study done in conjunction with the American Bankers Association, more than three-fourths of non-investment-grade middle-market companies now have access to the high-yield bond market.

Capital markets products now represent nearly 40% of middle-market companies' financing "wallet," accelerating the erosion of commercial banks' relationships and traditional sources of profits. At one major commercial bank, one-third of the loan syndication deals lost in the last year went to investment banking competitors. Further, profit will continue to mount as banks with section 20 powers use the profitability of high-end capital markets products to aggressively price credit.

The likely result? Traditional commercial lending for the middle market will soon become one-third to one-half as profitable as it is today, and these banks will face the prospect of being marginalized in their most valuable corporate relationships.

For banks to effectively compete in this new environment, there are three strategic alternatives: Focus on credit relationships; emphasize low- cost product specialization; or enter the investment banking arena.

Banks choosing to focus on credit relationships will increasingly be forced to target small-company clients, relying on more traditional credit and lending skills.

To succeed in this limited scope, they must have a critical mass of credit-centric relationships that are profitable and focus on developing efficient client acquisition capabilities to replace relationships as these migrate up market.

Far from being a "head-in-the-sand" approach, this strategy may be quite apt for many institutions, including smaller regional banks that are confident that business can grow given their distribution access and product capability.

Product specialists will focus on client companies that unbundle their financing and transaction product needs. These banks must have a low-cost position or distinctive capability in one or more product areas, with the potential to dominate a product category. Superior product development capabilities are essential as these banks must continue to innovate, leveraging scale and low distribution costs to remain competitive.

State Street Bank, with its custody, fund administration and passive management franchise is one example of this strategy.

Finally, entering investment banking is appropriate for those institutions whose core client franchise is at risk from product substitution, bundled buying, and/or predatory pricing.

With a focus on large and midsize company clients, these banks must develop the capability to cross-sell capital markets products to clients and, importantly, to extend their capital markets franchise beyond their traditional customer base. They must also be able to cement strategic, consultative relationships with clients. Many large banks are indeed pursuing this strategy, including BankAmerica Corp., Chase, and First Union Corp.

Although these three strategies can be viewed as distinct and separate, some players may pursue more than one option. To do so, a bank must maintain separate business systems, attain critical mass in each system, and actively measure and manage the cross-subsidies between them.

Which alternative-or combination of strategies-is best should be determined by realistically assessing a bank's competitive position, target customer base, and institutional capabilities. The potential upside of each strategy is different, but all are preferable to standing still.

Like it or not, the playing field in banking has changed. It's up to each institution to explicitly decide how it will compete. Doing nothing is not an acceptable option.

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