Many bankers are under pressure to increase earnings in the months ahead.
Such pressures arise partly because of widespread misperceptions that higher earnings necessarily represent more shareholder value. Higher earnings may be difficult to achieve, particularly if rate spreads fail to rise.
In that event, some bankers will adopt strategies that achieve their objective in the near term only by actually impairing shareholder value. In most cases, this unhappy result is unnecessary.
Perils of Cost Cutting
Some bankers will consider substantial cost restructuring by means of widespread expense reductions. Too often, however, cost-cutting programs are like using a hatchet for brain surgery, resulting in loss of corporate value and opportunities.
These programs may be so extensive and intense, with time schedules so tight, that anything labeled "expense" is a potential target. The problem is that many of the outlays that are accounted for as "expenses" actually are investments in customer relationships, information systems, and human capital.
Indiscriminate expense reductions thus often result in inadvertent and fundamentally irrational cutbacks in corporate capital accumulation. They probably even cause dissipation of some of these forms of capital already in place.
Under what circumstances are major cost restructurings beneficial? Certainly, restructurings are beneficial if they prune away actual excesses while preserving worthwhile investment programs and capital already in place. They are also beneficial to the extent that the gains from current expense reductions offset any sacrifices of investment opportunities and losses of existing capital.
This latter sort of result certainly is not an optimal one, and its achievement is likely to be more by luck than by design. Thus, a cost- cutting program can be little more than a crapshoot.
A banking organization that has pushed its underlying capital to the frontiers of its available opportunities is in a very different situation. Any further investment outlays, including on developing customer relationships, information systems, and human resources, would outweigh the additional shareholder value they could generate.
A bank maximizes its shareholder value by focusing its strategies and decisions on maximizing the net values of its underlying assets, and especially those of its customer relationships.
But for these banks, any attempt to increase near-term earnings must further reduce underlying shareholder value.
A seemingly logical option is to try increasing earnings by expending the sales of services. To do so requires more investment in developing customer relationships. Yet, in cases where the bank is already at its "opportunity frontier," this option must detract rather than add underlying shareholder value.
Worse, outlays on sales expansion usually are recoverable only over several or more years. Reported expenses will probably increase by more than income, actually reducing reported earnings as well as values.
The other option is to find ways to reduce expenses. If current expenses are already well under control, this option is likely to entail reducing reported expenses that actually represent optimal investment outlays.
If the enterprise is indeed at its opportunity frontier, expense reduction must reduce underlying shareholder value, even if it boosts near- term earnings by reducing reported expenses by more than it reduces income.
Few bankers seem to face the dilemma of being too close to their opportunity frontiers. That much is clear if only because of the general absence of value-based decision criteria. A positive consequence is that they probably have substantial opportunities for increasing both their near-term earnings and their true underlying corporate net worth.
Taking advantage of those opportunities requires carefully targeted cuts in reported expenses, including cuts in customer relationship investment.
Being well short of that value-maximizing frontier probably means that bankers should be able to identify many instances of significant over- investment. In particular, some types of customers have too little value potential to warrant investing in developing relationships with them.
Perhaps a historical emphasis on market shares has led to marketing programs that attract such customers indiscriminately. Some of the deficiencies are likely to be so obvious that relatively little data and analysis are necessary to identify them.
Upon identifying the most blatant cases, the appropriate course is to change the terms on which the bank will accept and service these relationships, either to endow them with value or to eliminate them.
Significant reductions in reported expenses should result from cuts in unproductive marketing investment. Reductions in actual current expenses may also be achievable by eliminating existing customers with negative value.
A point to remember here is that past investment of whatever sort is irrelevant. What is relevant are the possibilities for extracting positive values from all future income and outlays associated with these customers.
Perhaps an analogy here is using a butcher knife to cut away the surface fat. Of course, with elimination of the most obvious cases, this sort of approach will require increasing levels of refinement. One potential benefit would be an inducement to make more effective use of customer information.
Another benefit of the approach is to lead bankers toward a better understanding of the sources of their enterprise value and of how to manage and develop it. This understanding, by focusing directly on the value characteristics of the banking enterprise, better assures achieving shareholder value objectives.
Mr. Morgan is a consultant based in Falls Church, Va.