I It was only 20 years ago that John P. Evans Jr., then a 34-year-old vice president in the institutional sales department at First Union National Bank, was given an important assignment. "I was a task force of one to see if we could do the bond business in Florida," he recalls with a wry smile. It wasn't quite like selling U.S. Treasuries from the trunk of a car, but was still a far cry from Evans' world today, where as a senior vice president in First Union's Capital Management Group he oversees 33 sales people and 17 traders. "We were driving a Model T, and now we're in a Cadillac Seville," he says.
If the 62-year-old Glass-Steagall Act--a relic of the Great Depression that is nearly 10 years older than Evans himself--is repealed this year as seems entirely possible, the career of this soft-spoken New Orleans native will have spanned from one extreme to another. Two decades ago, commercial banks like First Union stood outside the capital markets like hungry beggars, thrown a few scraps but denied a seat at the table because of Glass-Steagall's prohibitions against engaging in securities activities. If Glass-Steagall is finally swept aside, then commercial banks--including many from outside the U.S.--could eventually dominate a business that was once forbidden to them. And in the opinion of many experts, regionals like First Union stand to benefit most of all. "Then we're driving a race car with the rest of the securities dealers," says Evans.
And yet who knows what to make of these rumors of reform that emanate from Washington? It's a matter of no small irony that after years of intense lobbying and many bitter contests in the halls and hearing rooms of Congress, the repeal of Glass-Steagall would have less impact today than when John Evans entered the business. The largest banks have already been granted limited authority to underwrite securities, while the smallest ones want nothing to do with it. Also, banks now are permitted to do everything in the mutual fund field but distribute the product themselves, and bringing this activity in-house would yield only modest savings. The other reform measure being considered in Congress--the ability to sell insurance or even own an insurance company--is of much greater interest to a broader cross-section of banks. But it faces fierce opposition from the independent agents, one of the toughest lobbies in Washington.
The likelihood that any product reform measure will make it through Congress this year is uncertain--although the legislative environment is clearly more supportive now than at any time in years. (For a full explanation, see story on page 32.) The ability to underwrite stocks or sell insurance is not a magic pill that will painlessly reverse banking's loss of market share in recent years. But it would be an important victory nonetheless, enabling the industry to win back some of its lost share in wholesale banking while facilitating its entry into insurance.
Microsoft Corp. Chairman Bill Gates' widely publicized remark that banks are dinosaurs has a ring of truth to it, and part of the problem is that they're not permitted to offer a full range of financial products in the most efficient manner possible--they've been penned up in a kind of regulatory Jurassic Park. "We simply need broader revenue sources to compete in the '90s," argues Roger Fitzsimonds, chairman and chief executive at Firstar Corp., a $15-billion-asset bank in Milwaukee.
A strong proponent of product reform is Randall Kroszner, an associate professor of business economics at the University of Chicago. Kroszner and a colleague, Raghuram Rajan, concluded in a major study that prior to Glass-Steagall, securities underwritten by commercial banks actually out-performed those underwritten by investment banks. This is contrary to the popular notion that commercial banks foisted the stock of shaky companies on naive investors, or that underwriting posed a systemic threat.
Repeal of Glass-Steagall would greatly change the securities market--more, perhaps, than banking itself. Businesses, especially middle market companies that are not routinely courted by major Wall Street firms, could see their financing alternatives expand. Not only would commercial banks be able to underwrite corporate bonds, but they also could help bring privately-held companies to the equity market for the first time and, in Kroszner's words, "really take a nurturing position." Many observers also predict a wave of mergers as regional brokerage firms--and perhaps even some large New York-based houses--link up with banks.
Kroszner believes that consumers, too, would benefit if the barriers between insurance and banking were removed, since maintaining different financial services subdivisions creates unnecessary complexity and raises transaction costs. Says Kroszner of product reform in general, "I think it's a very good public policy."
Merger Rumors
Repeal of Glass-Steagall might not have the same immediate impact on the securities business as did the ending of negotiated commission rates in the early 1970s, but its effect would be significant nonetheless. For most investment banks, Glass-Steagall's possible demise comes at a particularly awkward moment. The securities industry is experiencing one of its most difficult environments in years. Profits are down, and many brokers--including some of the biggest--are retrenching. Rumors of possible acquisitions of regional and even bulge-bracket securities firms by commercial banks are flying around Wall Street like ticker tape.
Why such talk? "I suspect the reason a lot of the firms are for sale is they realize being well-capitalized is an increasingly important part of the business," says Mark Mahoney, managing director and head of First Union's investment banking group. After several profitable years in which they've been able to build their balance sheets by selling equity and generating retained earnings, commercial banks have plenty of capital.
Investment banks "haven't realized the value of the balance sheet like banks have," agrees Jim Beqaj, president of Wood Gundy Inc., the securities subsidiary of Torontobased Canadian Imperial Bank of Commerce. And now, with revenue drying up and lacking deep pockets of their own, many firms are searching for a Daddy Warbucks.
Some of the largest commercial banks also have made credible strides of their own--most notably J.P. Morgan & Co., whose investment dealer subsidiary underwrote $9.36 billion in domestic stocks and bonds in the first quarter, edging out Salomon Brothers for sixth place in the closely followed underwriting sweepstakes. This is the first time a commercial bank has finished ahead of a bulge-bracket firm like Salomon. That tells Beqaj that even the biggest investment banks can no longer trade solely on the prestige of their names.
Beqaj, who is also an executive vice president in CIBC's corporate banking unit, says the Canadian institution has been investing heavily in the sort of infrastructure--credit and operations personnel, for example--that investment banks have been slow to match. "In the heyday of the investment dealers, those would be the last guys they'd hire," he says.
Canada provides an example of what might happen here if Glass-Steagall is repealed. When that country's version of Glass-Steagall was removed in the mid-1980s, most brokers there were not eager to join up with the banks. But after the U.S. and Canadian stock markets crashed in 1987, the ensuing bear market forced many brokers to seek out banks as merger partners.
Analysts and bankers say that logical buyers for many of the regional securities firms would be any number of regional banks. First Union, Banc One Corp., PNC Bank Corp., Norwest Corp. and SunTrust Banks Inc. have all been granted limited securities powers by the Federal Reserve and thus could be logical acquirers. Other candidates might be several of the large foreign banks, including Deutsche Bank AG, the Netherlands' ABN AMRO Bank or Swiss Bank Corp. The latter also have been given investment banking powers by the Fed, but might use an acquisition to expand more quickly.
The impact of product reform might not be as dramatic on the insurance side, which is a larger and more fragmented market than investment banking. But the insurance industry is going through its own challenges, including overcapacity and distribution inefficiencies. Most insurance companies sell their products either through independent agents or captive agency forces, but they might also like to wholesale through a lower-cost channel like a bank.
"I think over time, banks could get a significant share of the market if they improve their selling tools because insurance companies are having their own problems," says John E. Kojan, a managing vice president at First Manhattan Consulting Group. Kojan stresses that there needs to be some "skill building" first, just as banks had to learn how to sell mutual funds.
Banks could in time become a major distribution arm for insurers since they have access to large numbers of customers and a wealth of demographic information, which some of them are finally beginning to mine. They also have multiple distribution channels of their own. "Banks do have them all--they have the branch, the mail and the personal computer to some extent," says Kojan. The group most at risk may indeed be the independent agents, who are viewed by many of their own companies as a high-cost distribution mechanism.
Passage of reform legislation would be muted by the fact that some deregulation has already occurred. The Federal Reserve began giving commercial banks securities powers in 1987, beginning with Morgan, Bankers Trust New York Corp. and Citicorp. There are now 14 banks--seven of them foreignowned--that are allowed to underwrite both corporate bonds and equity. Another 23 have been given more limited authority to underwrite varying types of corporate debt securities.
But these Section 20 powers--so named after a section in Glass-Steagall--bring with them very significant restrictions. A bank must set up a separately capitalized broker/dealer subsidiary under its holding company and observe strict firewalls, including stringent guidelines for cross-marketing between the securities unit and the bank itself. Worse yet, these securities activities may not account for more than 10% of the broker/dealer's total revenues, which limits their growth and is a management nightmare.
Banks also have insurance powers, although here the situation is more confusing. All banks are permitted to sell various forms of credit life insurance, explains Michael Crotty, deputy general counsel for litigation at the American Bankers Association. State-chartered banks may do whatever their state allows, and 37 of them have statutes that grant their banks the same insurance powers national banks have. National banks in towns of less than 5,000 are permitted under the National Banking Act to sell any type of insurance--although this authority is being challenged in the federal courts despite a favorable Supreme Court ruling some months ago in a case involving annuities. Even the industry's right to sell title insurance is facing a legal challenge.
At the center of the controversy is the McCarran-Ferguson Act, a federal law that delegates regulation of insurance to the states. Crotty says all that's needed is a second federal statute specifically granting banks insurance powers. "It would clearly pre-empt state law," he says. Perhaps, but insurance agents are determined not to let it get that far. As this story went to press, the agents were working with House Commerce Committee Chairman Thomas J. Bliley on legislation that would give state insurance commissioners the power to regulate bank insurance sales. If they succeed in linking this measure to Glass-Steagall repeal as a condition, banking officials have warned publicly that the entire reform process might collapse.
How would a variety of banks take advantage of reform if it actually occurs? When it comes to investment banking powers, the smaller the bank, the less likely it is to use them. First National Bank of Long Island is a $400-million-asset institution that concentrates on small privately held companies and professionals, and does little business with public companies. Getting rid of Glass-Steagall, says chief executive officer Bill Johnson, "is a big bank issue." Johnson even questions whether repeal is a good idea, arguing that the stability of the banking system might be threatened if banks get into trouble. "It worries me," he confides.
George Schaefer Jr., CEO at Fifth Third Bancorp, a $15-billion-asset regional institution headquartered in Cincinnati, does support the idea of reform--but even he doubts that Fifth Third will start underwriting stock any time soon. "We're going to continue focusing on our four core businesses," he explains.
Repeal would be of some benefit to smaller banks. Firstar manages $2.7 billion in proprietary mutual fund assets, and would stop using an outside firm to handle distribution if allowed. But the savings would be well under $1 million a year, less than 1% of Firstar's $207 million in net income for 1994.
Most likely, the bank also would expand its municipal underwriting efforts--a permissible activity--to include revenue bonds, which are tied to special projects like stadiums. Currently, banks are only permitted to underwrite general obligation bonds--which are backed by the full faith and credit, and taxing authority, of the issuer. "But the homework is essentially the same," Fitzsimonds says.
Now the $64,000 question: "Will we really get into underwriting stock?" Firstar has a capital markets group in Milwaukee that provides companies within its four-state service area every service but underwriting. Fitzsimonds wonders if the potential revenue justifies the expense. "Frankly, this is where we and others need to do some thinking," he says.
The money center banks, all of which have Section 20 subs, are already a force in the securities business, even with their volume restrictions. "Ten percent of their revenue is still a big number," says Tom Long, a partner in the Washington law firm of Jones Day Reavis & Pogue. Morgan, Chase Manhattan Corp., Chemical Banking Corp., Bankers Trust and NationsBank Corp. have full debt and equity underwriting powers. BankAmerica Corp., Citicorp and First Chicago Corp. have permission to underwrite and deal in debt securities. If Glass-Steagall is repealed, "I think everyone agrees that the 10% lid probably comes off," says Long. "The Section 20s, which are already big players, would get to be even bigger players."
Among this top group, only BankAmerica would discuss the issue of product reform. "The repeal of Glass-Steagall is important to us--very important to us," says Vice Chairman David Coulter. The bank now has a long roster of corporate clients after its acquisition last year of Continental Corp. A recent Goldman Sachs Bank survey found BankAmerica has a primary relationship with 40% of the Fortune 500. Does Coulter want to offer full capital markets capability to this crowd? "You bet I do," he replies.
But the biggest beneficiaries of repeal would probably be the large regional banks--say, a $77-billion First Union rather than a $15-billion Firstar. First Union has aggressively expanded its capital markets activities over the last 18 months and sees underwriting as an indispensable function. "As a product, corporate debt and equity are crucial," says Sandy Curlett, president of Capital Markets Corp., the Charlotte-based bank's Section 20 sub.
Another good example is Bank of Boston Corp., which focuses on middle market companies in New England but has not sought Section 20 powers. If Glass-Steagall was eliminated, the bank would most likely add underwriting to its capabilities. "We want to be in a position of being able to leverage our relationships with the smaller companies," says Jamie Lewis, who runs the bank's loan syndication group.
One decision facing the banks is whether they build or buy these underwriting and dealing activities--or perhaps try a combination of both. There would seem to be no shortage of securities firms to acquire. "All sorts of people are talking to each other about joint ventures, capital injections and outright acquisitions," says Coulter. But there are also significant cultural differences that would have to be worked out. Brokers generally foster highly entrepreneurial environments that might clash with the more staid cultures of most banks.
The Culture Problem
First Manhattan consultant Alden Toevs prefers building to buying, and doubts whether the big U.S. banks will be a factor in the merger market. "We find it hard to believe that many money centers will go out and acquire a major investment bank--or would be able to," he says.
First Union--one of those regionals that analysts tend to identify as a possible acquirer--is inclined to build as well. Dan Mathis, co-head and managing director of its Capital Markets Group, says any deal would have to provide "the right cultural fit."
Mathis makes the well-worn but salient observation that a brokerage firm's assets "walk out at sundown." When it started building a high-yield trading operation, First Union worked with an executive recruiter to identify possible firms that it might acquire. Problem is, if they come to you as a group, they can just as easily leave as a group. Says Mathis, "At the end of the day, we couldn't get real comfortable with the firms."
There is also the issue of profitability to consider: Can banks actually make an adequate return underwriting stocks and bonds? The answer is unclear. Profit margins are tight in underwriting, and in many respects it's a scale business where volume is critical.
CIBC's Bequj says his Section 20 sub has no immediate plans to play in the U.S. equity market, which is already highly competitive. Instead, Beqaj has focused on building a derivatives and risk management operation, an area where he thinks CIBC can succeed--and get paid for its efforts. Indeed, Beqaj believes the key to profitability in capital markets is strategic focus. Even big banks can be all things to all people.
Beqaj describes the enormous cost of building an equity operation in the U.S. To be a factor in the new-issue market, you need a strong secondary market capability for liquidity--and that requires a trading desk. But the desk needs the services of an institutional sales team, which in turn requires the support of a top-notch research staff. "You say, 'Shoot, we're in the States. Let's stick a toe in the equity business.' Well, there's $200 million." And this for a business that might never be profitable! "I don't believe there's room for that (kind of thinking) any more," he says.
Of course, the profitability picture will be determined in part by how a repeal law is actually written. The Clinton Administration and Comptroller of the Currency Eugene Ludwig would permit any securities activity to be housed within a bank itself rather than hived off into a separate unit, as is now the case.
This would allow banks to escape the added capital and organization costs of operating a broker/dealer subsidiary, costs which lower profitability. But Congress may decide that running a securities shop out of the bank is too risky. "I'm not sure that's true," says one senior banker who's testified on Glass-Steagall in Washington. "But if you see it from a politician's point of view, they say, 'Hey, we've got to protect the deposit insurance fund.'"
There are a variety of other firewalls meant to separate a securities operation from its bank affiliate and thereby protect the fund. For many bankers, among the most troublesome are restrictions against cross-marketing between the bank and the broker/dealer. This tends to inhibit a realtionship management strategy that bankers say is another key to profitability. "If I could change only one thing, that would be it," sighs Mathis at First Union.
The interest in selling insurance is more broad-based than that for securities underwriting, in part because it's a logical addition to the retail product set that virtually every U.S. bank offers.
Insurance a Natural
Annuities have attracted the most interest thus far, perhaps because they're really more investment contracts than traditional indemnity products and go together with a bank's certificates of deposit and mutual funds like eggs, bacon and toast. "It's a great example of a product where it would be natural to help customers with that," says Don McMullen, executive vice president and head of First Union's Capital Management Group, which includes its brokerage, mutual fund and private banking units. First Union is licensing 800 of its retail bankers to sell annuities in its 1,300 branches.
Firstar also sells annuities, which Fitzsimonds says produced $10 million in revenue last year. He says that business "is growing very well" and should expand 10% a year for the foreseeable future.
But it's unsettling to manage a business whose very legality is under constant attack, to say the least. Once McMullen is done training and licensing his 800 sales people, will he be allowed to use them? "We still need the general environment changed so I can get out there and serve my customers," he says.
First National's Johnson agrees. A nationally chartered bank in a town with fewer than 5,000 people, First National started selling annuities less than a year ago. Johnson isn't certain whether annuity revenue "will ever be significant" for the bank--but he wants to retain its legal rights all the same. "Removal of that cloud for the industry would make sense," he says.
Banks also have expressed interest in selling life insurance, although to a lesser degree. Property/casualty insurance seems to hold the least appeal of all. Firstar is one of 16 banks grandfathered under federal law to market all kinds of insurance irrespective of location, but Fitzsimonds says he's never earned much money pitching P/C products.
Acquiring an insurance company may be the least interesting option for most banks. Their operations are quite different, especially on the P/C side. "The risks of property/casualty insurance are better left in the traditional insurance companies," says Joan Ellis, an equity analyst at U.S. Trust Corp. "Would you like to be writing a lot of homeowners insurance in California?"
But doubtless there are banks out there who would still see the value in cutting out the middle-man--just as many have eschewed third-party marketing ventures to establish their own proprietary mutual funds. One example might be a small insurance company that specializes in annuities and up-scale life products that could be sold to trust customers. "I think that's something we should investigate," says First Union's McMullen.
Even if few banks do acquire an insurance company or underwrite stocks and bonds, the purpose of reform should be to give all financial service companies the freedom to define their own future in whatever manner does not threaten the banking system.
Beqaj at CIBC says the financial industry has long been highly segmented: A broker did one thing, a bank another and an insurance company a third. But he expects to see far more diversity in years to come as all financial institutions look for their niche and devise strategies that effectively set them apart. Indeed, that process is already well along. Product reform would set the banks free as well, giving the dinosaurs the chance to evolve into whatever form Mother Nature intende.
RELATED ARTICLE: First Union's Capital Concept
In January 1994, First Union Corp. launched an ambitious plan to expand its capital markets operation despite the conventional wisdom that corporate banking is a business to avoid at all costs. But in First Union's case, either it served a customer base that had changed as the bank expanded--or risked losing them to another bank or securities firm.
"As the bank has grown, the mix of its client base has changed," says Sandy Curlett, president of Capital Markets Corp. First Union's Section 20 subsidiary. "We want to help our clients meet a financing need when that need requires more than traditional commercial bank products," he adds. "And that has continued to drive us."
Since then, First Union has pushed hard to develop its loan syndication, private placernent, asset securitization, derivatives, trading and mergers and acquisition advisory capabilities. The bank also has been aggressively recruiting capital markets veterans--including Curlett, previously a managing director at J.P. Morgan & Co.
The target of all this energy is more than 100,000 companies in a fast growing, eight-state region. First Union says that customer response has greatly exceeded its expectations. Senior vice president John Evans, who oversees the trading operation, points to the bank's private placement deals, which last year totalled $667 million. "We've been overwhelmed by the number of deals that have come in from within our franchise," says Evans. "It's like they were waiting for us to put that (capability) in. And I think it will happen on the corporate debt side as well."
To that end, First Union has applied for Section 20 authority to underwrite corporate debt and equity. Curlett hopes to receive approval from the Federal Reserve to underwrite bonds by mid-year--and equity by early 1996. Currently the unit is limited to municipal revenue bonds, commercial paper, government securities and the like.
The ability to underwrite securities is crucial to the bank's Capital Markets Group's plans--so much so that it strongly favors repeal of Glass-Steagall. "The client needs access to capital markets products," says Co-Head Dan Mathis.
