Two decades ago, banks lost their prime corporate business to the commercial-paper market.

A decade ago, deposit bases were eroded by the advent of money-market mutual funds. At the same time, thrifts and banks began to feel a margin squeeze from the exploding mortgage-securities market.

Now it appears that disintermediation may be closing for a the kill - and this time the targets are virtually every asset on the balance sheet.

Peril and Promise

We have entered an era in which assets once thought to be illiquid - such as home-equity loans, credit cards, auto loans, commercial mortgages, equipment leases, even working-capital loans - are being securitized with increasing frequency.

In 1991, Wall Street issued more securities backed by these traditional bank products than it issued in corporate equity offerings. And this doesn't include more than $200 billion in residential-mortgage securities.

Though emerging secondary markets present opportunities for banks, I'm very concerned that we bankers will once again underestimate the threat of disintermediation that these markets pose.

Without preemptive and strategic positioning, banks and thrifts of all sizes will be the biggest losers when the secondary markets for traditional portfolio assets burgeon.

Emerging secondary markets must be taken seriously and addressed strategically if the banking industry, in one form or another, is to survive.

Key Trends

The importance and relevance of secondary markets can best be illustrated by considering how their emergence relates to seven key trends that are shaping the future of commercial banking.

* Legislative gridlock.

The banking bill passed in November of last year, affectionately termed the Federal Deposit Insurance Corp. Improvement Act, was a major disappointment for commercial banks.

Certain key provisions of the Treasury's bill that would have made the industry more competitive failed to make it into the final bill. These include provision for bank expansion into securities, insurance, and mutual funds; for industrial ownership of commercial banks, and for nationwide branching.

Recent legislation has already had a tremendous impact on all our financial institutions, and many of the chapters are still to be written. We are only part way through a reordering of the regulatory landscape that will define our operating environment in the future.

Meanwhile, nonbank competitors continue to disintermediate the banking industry, because of distinct cost advantages in their product delivery systems. A major portion of this cost advantage flows from the nonbanks' ability to avoid the regulatory burden hamstringing our industry.

Against this background of regulations, increased disintermediation, and heightened attention to balance-sheet management, banking participation is secondary markets has become inevitable.

* The emergence of regulatory risk.

This new type of risk needs to be managed as diligently as credit or interest rate risk.

If a bank's regulatory rating goes down, the rating assumes the immediate and highest priority, because it alone may determine long-term survival. (And the long term may not be very long, in view of the mandatory early-intervention provision of the 1991 law.)

Securitization can be an effective survival strategy when regulatory risk threatens an institution's viability.

Capital ratios, both core and risk based, can be strengthened by shrinking the balance sheet. And gains on asset sales can offset credit losses while an institution heals.

A drawback to this strategy is that usually the most liquid and least risky assets are the ones that are securitized and sold. This shrinkage, therefore, can increase the perceived risk of the institution and thereby lower the level at which its equity trades.

* The increasing importance of capital.

The stern regulations issued under the new law will require capital well in excess of regulatory minimums for banks to retain management discretion.

The law will also result in a major wave of regulations, and that means costs.

These regulations address brokered deposits, risk-based deposit insurance premiums, asset growth, dividends, and officer compensation.

All are capital based, proving once again that capital is king. New powers, relief from supervisory controls, and reduced supervisory costs will all inure to institutions that maintain high levels of capital.

However, because of the competitive disadvantages of banks and thrifts within the broadly defined financial services industry, capital will flow to the better-positioned nonbank financial intermediaries.

This will force the banking industry to rely on retained earnings as a primary source of capital.

Currently, the only financial institutions successful in the capital markets are:

* Those that are strategically positioned to compete head-on with the efficiencies of nonbank competitors.

* Those that have carved defensible market niches for themselves.

Faced with a shortage of new capital, more institutions are coming to see the secondary markets as a capital-enhancing source.

Equity returns will also accrue to lenders who can use securitization to diversify risk and engineer their balance sheets as they see fit.

Geography, duration, borrower concentration, and collateral exposures can all be diversified. Banks can begin to use quantitative techniques akin to the securities industry's portfolio theory.

* Redeployment of capital on a risk-adjusted basis to profitable lines of business.

Recognizing that they cannot be all things to all people, banks need effective strategic planning and the ability to evaluate each line of business as an autonomous profit center.

Securitization can help this redeployment in a number of ways.

Institutions with strong customer franchises and marketing resources can use securitization as a leverage tool. This can produce tremendous equity returns.

Take MBNA Corp., the big credit card issuer. Of its $8.8 billion in total loans, 60% have been securitized. And MBNA is one of the nation's most profitable banks, with a 25% return on equity last year.

The primary object of a secondary market is improved liquidity. In a capital-starved industry, that's highly important.

By turning loans and mortgages into marketable securities, Wall Street has found a way to channel money from pension funds and other institutional investors into private lending, using banks as originators rather than as providers of permanent funding. For banks to avoid being pushed out of the loop altogether, they must develop new ways to add value to the securitization process.

Banks that position themselves to profit from the origination, underwriting, issuing, servicing, and trading of these securities will merely be giving up the return that traditionally accrued from taking investment risk.

But taking that risk is far and away the toughest way to make a buck. Chargeoffs as a percentage of bank loans have increased 600% over the last 30 years.

Banks must determine where they can add value in secondary-market activities and develop these capabilities. Otherwise, the show will go on without them.

* Rapid reduction in the industry's overcapacity.

Reduction in overcapacity, and the associated trends toward economies of scale, performance-based pay, technology, and outsourcing will probably accelerate because of the continued growth of securitization.

Banks are struggling to improve their efficiencies because nonbanks, at this point, have them beat hands down. The cost of running mutual funds is roughly 1% of assets under management. Fannie Mae runs at a mere 20 basis points. Banks run at ratios of 3% to 5%.

Bank managements have two basic options:

* Drastically reduce costs, to become efficient competitors.

* Specialize in higher-risk portfolio lending in areas the secondary markets do not serve.

For banks choosing to become market-efficient competitors, securitization provides the liquidity to increase operating leverage.

And banks that shrink in terms of assets and capital need not shrink in profitability if they increase the value of their clientele.

* Renewed emphasis on asset quality and balance-sheet strength.

For banks to survive competitively, their portfolios will have to be as liquid as possible, and the inherent risk as measurable and diversified as possible. These requirements further underscore the need for strong asset/liability management.

Just think of the perverse incentives created by risk-based capital.

Currently, for every $1 of consumer assets sold you can buy at last $5 of agency collateralized mortgage obligations and real estate mortgage investment conduits (Remics), assuming some cushion in core capital.

Whether the Basel boys anticipated it or not, risk-based capital - intended to strengthen the banking industry - has primarily been a boon for Wall Street.

If the banking industry's chief skill becomes collecting insured deposits to warehouse in government and agency securities, we've got a hell of a lot of overhead to cut.

Capital guidelines based on interest rate risk will also create additional incentives for securitization.

These guidelines, combined with the continued push in some quarters for mark-to-market accounting, will make it increasingly difficult for banks to hold long-term assets. Mortgage banking may become as common as portfolio lending for all types of assets.

* Asset/liability management becoming the industry's strategic lifeblood.

Banks will be able to evaluate investment and borrowing decisions rationally and consistently by three criteria:

* Risk-adjusted return on equity.

* How an asset or liability contributes to the optimization of the balance sheet.

* How this contribution raises or lowers the cost of equity.

Asset and liability management will allow banks to realize secondary-market opportunities and avoid having the wool pulled over their eyes by investment bankers who will be pushing product - and deals, and fat fees.

Think of how many bankers today are buying mortgage securities using the option-adjusted pricing assumptions of the investment bankers who are selling the product to them.

As the secondary markets develop further, bankers must realize that a decision to hold any asset means that return on equity will be higher than securitizing the asset, selling it, or both would yield.

If detailed asset/liability models do not exist to test these implicit decisions, banks may have investments that are economically irrational.

The 1,001 flavors of securities now available are complex and difficult for some to understand. But banks must be as critical in evaluating these decisions as they are in major credit and strategic-planning decisions.

Either a high level internal asset/liability function must act as a check on those pushing product or external consultants must be brought in to serve as investment advisers.

Decisions to Make

Each of these major trends makes commercial banks' use of secondary markets more important.

Banks can use the secondary markets for strategic positioning. The particular position will depend on the size a bank aims for and the strategy embraced.

* If you are going to be a large, full-service powerhouse, understand the levels of cost efficiency and capital-market relationships that will be required to compete with nonbanks.

* If you are a community bank, understand the types of businesses you can exploit in your contest with those hungry to securitize the world. Be realistic about your ability to originate and hold commodity consumer products profitably.

Take the Initiative

Standardization of certain products will allow all banks to tap into secondary markets. Try to take the lead in developing this standardization.

Instead of resisting these trends, embrace them (to the extent our antiquated laws will allow). Use these trends to lower your cost of equity and to increase ROE.

As secondary-asset markets grow, banks will need to fight merely to maintain their current share of financial markets. But banks also have an opportunity - to be visionary in the development of these new markets.

Begin positioning yourself strategically to participate in the emerging secondary markets. Push with unprecedented urgency for worthwhile bank reform.

Conservative wisdom, a strength of the banking industry, can be leveraged. Banks should use the sophisticated tools of strategic planning, technology, asset/liability management, and credit management to steer toward survival and success.

We don't have to wait and see what happens. We can make it happen.

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